What is an auto loan?

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If you want to buy a car, you must first arrange for vehicle financing. An auto loan is simply money you borrow to pay for the vehicle. Loan specifics vary, which means comparing your options and getting the right loan could save you hundreds or thousands of dollars over time.
What is an auto loan is
An auto loan is a type of loan that allows you to borrow money from a lender and use that money to purchase a car. You’ll have to repay the loan in fixed installments over a set period, and interest will be charged on your borrowed money.
If you have a high credit score, you may qualify for a lower interest rate, saving you money over time. Your credit score helps determine a required down payment and the initial loan amount you’re eligible to borrow.
Key terms
- Interest rate
- This is the annual fee the lender assesses to borrow the funds needed to buy the vehicle. A higher credit score or shorter loan term generally equals a lower interest rate.
- Annual percentage rate (APR)
- The APR is the total borrowing cost of the loan, including the interest rate and other fees, expressed as an annual percentage.
- Down payment
- You will pay this amount to the lender before taking out the loan. It will be applied toward the total purchase price. The more you put down, the lower your monthly payments will be.
- Loan term
- The loan term or repayment period is the window of time during which you’ll make payments on the auto loan.
- Principal
- This is the amount you borrow to purchase the vehicle minus the interest and fees. The principal plus the down payment equals the cost of the car.
- Total cost of the loan
- This figure includes the principal, interest and fees paid to acquire the vehicle.
How auto loans work
Auto loans come in a few varieties, including dealer financing, car loans from banks or credit unions and loans from online lenders.
The type of loan that’s best for you depends on factors like your credit score, the loan amount and the vehicle you want.
Dealer financing
Dealer financing is the easiest type of loan to get since you can do your shopping and financing in one spot. The dealer will likely check your credit. If you have a strong credit score, you may qualify for a promotional rate from the manufacturer if you go through a certified dealership.
But dealer financing tends to come with a higher interest rate. Dealers often take a commission or markup when they match you with financing from a bank or credit union.
Bank or credit union auto loan
You can also apply for a car loan at a traditional bank or credit union. The lender funds these loans, so you won’t have to go through a dealer. However, it may take more time than going through a dealership. Expect it to take at least one business day to get a loan from a bank or credit union, up to a week.
Lenders often have a minimum and maximum loan amount, so be sure the lenders you’re looking into offer the amount you need for your new car.
Online auto loan
You can also apply for an auto loan online. These loans are often processed remotely, but the steps are similar to getting a car loan from a bank or credit union. It may take as little as one business day to get approved.
As a consumer, you can choose between financing your purchase through the dealer (indirect financing) or finding and securing your own lender (direct financing). Indirect financing is convenient and can open options for borrowers with bad credit. But you are likely to find more competitive rates shopping on your own for a loan.
How to compare auto loans
Like mortgages, the best way to compare auto loans is to look at the key costs — including interest rate, term and fees — along with the estimated monthly payment and the total payments over the loan term.
Annual percentage rate
The APR is one of the most important numbers when deciding on a loan, as it determines total borrowing costs. An APR is set based on your credit score, income and the term and amount of the loan.
Expect a higher interest rate if you’re in the market for a longer-term loan or if your credit score is fair or poor. A shorter loan term or higher credit score means you’ll likely have access to better rates. The lender will also factor in fees, so review the loan’s structure.
Ideally, you want a lower APR to get a more affordable monthly payment and keep more money in your pocket. An APR just a few points higher could make the loan far more expensive.
To illustrate, imagine you get a 48-month, $36,000 auto loan with a 6 percent interest rate. The monthly payment will be $845, and you’ll pay $4,582 in interest over the loan term. But if your rate is 8 percent, you’ll pay $879 per month and $6,186 in interest for the duration of the loan.
Term
You have a set number of months to repay your auto loan. A typical auto loan term ranges anywhere from 24 to 84 months. If you plan to purchase a new car and keep it for a long time, you’ll owe a lower monthly payment by taking out a longer-term loan — but you’ll pay more interest over time and be charged a higher interest rate. To save that money, take out a shorter term. Just make sure the payments are well within your budget.
For example, a $25,000, 36-month loan with an interest rate of 5 percent will cost you $749 per month and $1,974 in interest. A loan for the same amount and interest rate with a 60-month term has a far lower monthly payment of $472, but the interest costs are $3,307 — a difference of $1,333.
Fees
The two main fees you may see are the origination fee and the documentation fee. The origination fee is the amount you pay to secure the loan. The documentation fee covers the lender’s costs for securing your loan.
The bottom line
Simply, a car loan is an agreement between the lender and you, the borrower, allowing you to borrow money for an agreed-upon term to purchase a vehicle. While getting a car loan can be more complex than getting a personal loan, it is still possible to do it yourself and land a good deal. Doing so just takes time and research.
FAQs about auto loans
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To transfer a car loan to another person, you have two options. The most straightforward is to sell the car to the other person, who then takes out a private-party auto loan to pay off the lender. Alternatively, you can refinance the loan in the other person’s name. In this case, both you and the co-signer must sign the loan. The car’s title will be updated with the co-signer’s name alongside yours.
You will then have to refinance again to remove your name from the loan and title. It’s best to only attempt this if significant time has passed since the car was last refinanced, due to the potential negative impact on your credit score. If you decide to refinance, it’s best to have a co-signer with a high credit score and income to improve the chances of approval. -
Though loans on new and used cars work the same way, the details can differ. Pre-owned car loans typically have higher APRs than new car loans, but the loans often have shorter repayment terms. This means that, while you’ll pay more in interest, you’ll also get to the point of being car payment-free sooner.
In many cases, pre-owned car loans may be more accessible to a broader range of credit types than new car loans. In addition to being easier to get approved for, pre-owned car loans may also have lower down payment requirements. And because used cars typically cost less than new vehicles, loans for pre-owned cars tend to be for smaller loan amounts than new car loans. -
Auto loans and leases are different. An auto loan involves buying a car and making payments until the loan is paid off. A lease involves renting a car and making payments over time until the lease is up. At the end of a loan, the buyer owns the car. But at the end of a lease, the lessee has to either return the car or buy it.
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