Car title loans: What they are and how they work

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All loans come with risks if they’re not repaid on time. However, a car title loan carries an especially troubling consequence if you fail to meet your payment obligations: The lender can take your vehicle.

Before you consider getting a title loan, consider the potential potholes you’ll hit if you use your vehicle as collateral to borrow money.

What is a title loan?

Car title loan definition 

A car title loan is a short-term loan that lets you secure a small amount of money in exchange for giving the lender the title to your vehicle. You’ll also pay a sizable fee to borrow the money.

Let’s say you own a car worth $5,000, and you find yourself in an emergency situation that requires $1,000. A title loan lets you borrow against your vehicle, so you can get that $1,000 quickly. Just as a mortgage is backed by your home, a title loan uses your vehicle as collateral.

“One of the main pieces of information that people need to understand about a title loan is that it uses the equity in your vehicle for collateralizing the money you will borrow,” says Bruce McClary, vice president of communications at the National Foundation for Credit Counseling.

In most cases, you need to own your vehicle outright to qualify for a car title loan. The term “car” may be in the product name, but these loans also can be available for motorcycles, boats and recreational vehicles.

While some lenders will offer loans if a car is still being paid off, most require the owner to hold the title with no debts attached to the vehicle. Consumers typically can borrow between 25 and 50 percent of the car’s value.

How do title loans work?

Car title loans come in a couple different varieties. Some are single-payment loans, meaning the borrower has to pay the full amount of the loan plus the interest rate fee within a month or so. Installment loans, with similarly high APRs, can be paid back over three or six months, depending on the lender.

When applying for a car title loan, prepare to show the lender a clear title, proof of insurance and a photo ID. Some lenders ask for a second set of keys.

While getting a title loan may be easy, the convenience comes with serious costs and risks, according to Graciela Aponte-Diaz, director of federal campaigns at the Center for Responsible Lending.

“Some car title lenders install a GPS device – nicknamed a ‘kill switch’ – that can prevent the borrower’s car from starting, using this practice as a means of collecting a debt or making it easier to seize the car,” Aponte-Diaz says. “In addition to being (the) primary means of transportation to work, the doctor and elsewhere, a car is often the largest financial asset that a person has. The looming threat of losing your car is anxiety-inducing to put it mildly.”

Downsides to title loans

The biggest downsides to title loans are a short repayment period, sky-high interest rates and the potential loss of your car if you default.

“These are usually short-term loans with very tight repayment cycles,” McClary says. “If you can’t pay back the loan when it’s due, it’s rolled over into another cycle with more fees. It creates a very difficult situation for people who are already struggling to repay. It is the exact definition of the cycle of debt.”

In addition to tight repayment deadlines, car title loans have overwhelmingly high interest rates. Lenders often charge 25 percent each month in financing charges. On a $2,000 loan, you’ll pay an additional $500 in interest if the loan is repaid in 30 days. If you’re late with your payment and those interest charges pile up, the loan can wind up costing a lot more than the initial sticker price.

The biggest downside, though, is possibly losing your car. If you can’t pay it back, the lender can take your vehicle. In 2016, a study from the Consumer Financial Protection Bureau found that 20 percent of those who take out title loans have their vehicles seized.

Alternatives to title loans

With such serious downsides, McClary recommends reaching out to traditional banks and credit unions to explore other, less costly lending options.

“A lot of people might avoid traditional lenders because of assumptions about their credit,” he says. “That’s the most dangerous thing you can do. You’re cheating yourself out of money you could potentially save.”

Even if you don’t have a bank account, have a lower credit score or have struggled with poor financial decisions in the past, it’s worth investigating all your loan alternatives. “It’s interesting how flexible these traditional lenders can be,” McClary says. “There are a lot of credit unions that are willing to work with unbanked customers.”

McClary says he rarely advises adding to credit card debt, but he highlights that they’re a better option than a title loan. “If you have unused credit on a credit card, you could rely on it to help cover your cost,” he says. “In most cases, the interest rate on your credit card is going to be much less than what you end up with on a car title loan. And that route prevents you from potentially losing your vehicle.”

Bottom line

If you decide a car title loan is your only option, make sure you understand the terms of the loan. Title lenders are required to show them to you in writing before signing, and federal law requires that they be honest and upfront about the total cost of the loan. And remember that those costs are most likely not worth the risk.

“Car title loans often lead to people drowning in debt and losing their car,” Aponte-Diaz says. “Car title lenders frequently put people in a worse position than before they took out the loan.”

Written by
David McMillin
Contributing writer
David McMillin writes about credit cards, mortgages, banking, taxes and travel. David's goal is to help readers figure out how to save more and stress less.