An auto loan is a loan taken to purchase a motor vehicle. It’s a type of installment loan where the lender covers the needed cost of buying a car, SUV, truck, or motorcycle, and the borrower repays the amount with interest over a specified time period. Payments are usually made every month, and the loan is secured by the value of the purchased vehicle.
What is a Secured Loan?
A secured loan means that a borrower must offer up a valuable item to serve as collateral. In case the borrower is not able to continue repaying the loan, the lender can repossess the collateral. Mortgages are a typical example of secured loans, where the borrower’s real estate acts as collateral. In the case of an auto loan, the borrowed amount is secured by the purchased vehicle.
The borrower doesn’t technically own the vehicle until the loan is fully paid off; the lender does. Right after the last installment is paid, the borrower is considered the legal owner of the vehicle.
The great thing about secured loans is that they may come with lower interest rates than unsecured ones. However, a person’s credit score is an important factor when taking out an auto loan, and the better the credit score, the lower the interest rate.
How Does an Auto Loan Work?
Auto loans are loans paid off in a regular series of payments called installments. Installments are typically paid monthly, and most auto loans are three to six years long. A shorter term means less interest and a lower overall cost. However, it comes with a higher monthly installment, which can stretch your budget. A longer term usually means a lower monthly payment, but the overall cost of the loan will be higher.
An auto loan consists of two parts: the principal and the interest. The principal is the amount borrowed, and it is determined by the value of the purchased vehicle. For instance, if you need $15,000 for a car you are planning to buy, then the principal would be $15,000.
The interest is charged on top of the principal, and it is essentially a fee lenders charge for borrowing money. The main expense is the interest rate, which is a certain percentage of the principal over a specified period.
For instance, if you borrowed $15,000, and the yearly interest rate is 5%, it means that you need to pay $750 in interest for the whole year, or $62.5 each month on top of the principal amount.
Keep in mind that an auto loan may have other fees besides the interest rate. That is why it is best to look at the annual percentage rate (APR) as it shows all the costs associated with a loan.
Auto loans are generally amortizing, meaning that each payment goes towards both the principal and the interest. The loan gets a little bit cheaper with each installment, since the principal gets lower, which means that the charged interest declines as well.
Where Can I Get an Auto Loan?
There are essentially two ways you can get an auto loan. You can either get it through a car dealership or directly from a lender.
Dealership financing is the easiest and fastest option, as you can get a loan in the same place you are buying your car. Dealerships work with lenders, and you should be able to finish all of your paperwork in one visit. However, this option is slightly more expensive due to a higher interest rate for the borrower.
If you want a more affordable option, you can find the car you want and go directly to a lender to secure financing. This option results in lower interest rates since there are fewer parties involved. The purchased vehicle still acts as collateral, and the lender technically owns the car until the loan is fully paid off.
What’s the Difference Between an Auto Loan, Auto Lease, and Title Loan?
While an auto loan is taken to purchase a car, an Auto lease refers to renting one. A lease is either based on a certain time period or number of miles driven, but at the end of it, the car still belongs to the dealer.
While an auto lease is a more affordable short term option due to smaller payments, with an auto loan you actually own a vehicle after the loan is paid off. Keep in mind that some auto leases come with an option to buy the car at the end of the leasing period, but some do not.
With title loans, you are taking out a loan based on the value of a vehicle you already own. It is usually 25–50% of the car’s estimated value, and the vehicle acts as collateral in case a person cannot repay their loan.
In contrast to the long-term installment structure of auto loans, title loans are short term and come with higher interest rates. For instance, while auto loans usually come with a 5% yearly interest rate, title loans have an average of 25% interest per month.
The full amount of a title loan has to be paid at the end of the short-term period, and if the borrower cannot repay, the lender usually gives them the option to roll over their loan. A rollover refers to paying an additional fee to get more time to pay back the loan. However, with prolonged term comes more interest, which further increases the costs of borrowing.
Because of the high rates, rollover, and history of deceptive practices by some lenders, title loans are classified as a form of predatory lending. That is why it is recommended to opt for safer and more affordable alternatives