How do car loans work?
A car loan is a type of financing used specifically to purchase a new or used car. After buying the car, you’ll make monthly payments of both principal and interest until the loan is fully paid off. Auto loans are usually secured loans — the car itself is used as collateral and can be repossessed if you don’t make payments.
How much you can borrow and what interest rate you get depends on the lender and your personal financial situation. The best way to ensure you’re getting the best deal available to you is to compare offers from multiple lenders before signing on to any car loan.
Auto loan rates
The average car loan rate is 5.15% APR, according to a 2020 Experian study. But the rate you get can vary depending on your credit. The average rate for people with a credit score above 780 is 3.24% APR. But those with a 500 score got an average rate of 13.97% APR.
Some dealerships offer 0% APR introductory rates to move cars off the lot. Usually, this lasts for about a year before the regular interest rate kicks in. But usually, you need a credit score of 670 or higher to qualify for these kinds of deals.
Other factors like the type of car you buy and loan term you select can influence your rate. Generally, new cars and short terms get the lowest rates. Used cars from private sellers tend to land the highest rates.
What’s a good interest rate on a new car loan?
Anything below 5% is considered a good interest rate on a new car loan. However, you won’t be able to qualify for a good rate on a car loan unless you have good to excellent credit.
What to know before you apply
Here’s the financial, lender and car loan information you should have on hand before you apply.
Your budget
Before you compare lenders, calculate how much you can afford to pay for a down payment, monthly repayments, any fees and your loan’s overall cost. Look up your state’s taxes and fees associated with purchasing a car and add them to the cost of each lender you’re considering.
Not all lenders require a down payment. But experts recommend that you put down at least 10%.
Rates and fees
Compare the rates and fees available with multiple providers. Your loan’s APR is interest and fees expressed as a percentage and is the easiest number to compare.
But it’s useful to look at them separately since they can increase your loan balance or the upfront cost of your loan. Some lenders charge an origination fee of 1% to 5% of the loan amount.
Terms
In addition to APR, the length of your loan term also affects the overall cost. Your loan term is the amount of time you have to pay off your loan.
A short-term loan generally results in higher monthly payments but a lower total loan cost. A longer loan term gives you lower monthly payments, though you’ll ultimately pay more in interest.
Available rebates
If you’re financing with a dealer, ask about any cashback discounts to avoid leaving money on the table. Three main types include cash rebates, low-interest dealership financing and special leases. Government rebates for low-emission or hybrid vehicles are also available in many states.
Preapproval
Many lenders allow you to lock in rates and terms for a car loan so you can use it to shop around at dealerships as a cash buyer. If this is available, ask how long your offer is good for. Typically a preapproval offer is good for 30 to 60 days.
Lender repayment policies
Find out if you’ll be able to repay your car loan early without penalty or if you can make additional payments without being charged a fee. These features can save you money if you plan on paying the loan off ahead of time.
Customer reviews
Quickly scan online forums and review sites to see what people say about each lender. Are interest rates high? Do people have trouble making repayments? If anything sounds sneaky, run.
Additional services
Some lenders hold your hand throughout the process of getting financing, and others don’t. Consider the help if you don’t know what you’re doing — but also ask: Is the lender genuinely helpful or just pushing you into partners’ laps. If information isn’t available online, it’s worth calling a customer service representative to get a ballpark answer.
4 red flags to watch out for
Lenders or dealerships advertising any of these four “perks” should ring the alarm bells — or at least prompt deeper research.
- There’s no credit check. Dealerships often don’t run a credit check for buy-here-pay-here loans, but these loans can cost more than one from a reputable lender. Direct lenders advertising no credit check, however, could be a scam.
- It lets you take your car home before approval. This could be the sign of a “spot delivery scam,” where a dealer calls a few days later to announce that financing fell through and you now need to renegotiate your loan at a much higher price.
- It lies about your credit score. Some dealerships con borrowers into paying higher interest by telling them their credit score is worse than it actually is. Yet another reason to check your credit report before comparing lenders.
Where to get a car loan
Back in the day, your financing options were limited to dealerships and affiliated lenders.
Now you have more options beyond traditional financial institutions, including online upstarts competing for your business.
- Banks. Chances are that your bank offers auto financing or a personal loan you can use to purchase a new car. It’s a relatively hands-off experience, and only applicants with good credit typically qualify.
- Credit unions. Credit unions often offer financing with lower rates and more lenient credit requirements. But you need to join to qualify, which can add time to the process.
- Online lenders. Online loan providers can offer faster funding for people with damaged credit or who are new to auto financing. Some can also help you find a car at a dealership.
- Online connection services. Loan connection services could be an ideal option if you have bad credit since many offer loans with low or no credit requirements — though it won’t be cheap.
- Dealerships. You can always try to get financing directly from your dealer, though you might need to become a master negotiator to dodge typical dealership tactics.
Benefits of online car loans
Online auto loans boast convenience — and most banks, dealerships and manufacturers offer online applications to speed up the process. You won’t need to know the vehicle you want ahead of time, and lenders frequently offer 30-day preapproval periods so you can shop around to find the right car.
- Preapproval lasts 30 days or more
- Online lenders may approve your loan the same day you apply
- Banks, credit unions, private lenders and dealerships offer online applications
- Quick quotes make it easier to shop around
With an online lender, you can often get better rates than at a bank or credit union, especially if you have good credit. Some online lenders will also work with borrowers with poor credit.
If you’re not sure where to start, online marketplaces help you compare offers from multiple lenders by filling out just one online form. But interest rates vary by lender, and you may pay extra fees.
Be sure to confirm your lender is legitimate as well. Most are, but you should still research the lender’s website security, business practices and borrower reviews to make sure it’s legit before applying.
How do I apply for a car loan?
The car loan application process can vary depending on the type of financing you choose. Starting the process online with a bank or online lender involves more steps, but you have the advantage of getting preapproved for the loan and taking that offer to multiple dealerships. Although starting at the dealership is quicker, you lose some negotiating power.
What happens during the application process
1. Get preapproved
2. Choose your loan
3. Submit documents
4. Read the contract
5. Purchase the car
6. Sign paperwork
Before you apply, check that you know these six pieces of information
- How much you can afford for a down payment
- How much you want to pay each month
- Your state’s required taxes and fees
- Your credit score
- Which vehicle you want to buy
- The lender’s eligibility requirements
Have these three documents handy
- Your driver’s license
- Your insurance card
- Employment verification — tax returns or recent pay stubs
How to apply for an online car loan
Every lender is different, but these are the basic steps you’ll need to follow when submitting a loan application:
- Browse the table above and find a lender that fits you.
- Choose the Go to Site link to be redirected to the lender’s website.
- Fill out the application with your personal and financial information.
- Submit your application.
Most lenders will be able to tell you if you’ve been approved within a few minutes. View the interest rate and potential fees before you sign the loan contract. This makes it easy to compare loans.
Once you’ve decided on a loan, sign the necessary documents and submit. You’re ready to step into a dealership with financing to back you up.
3 questions to ask before you get a new car loan
- What’s the final cost? It’s essential that all the costs associated with the car loan are established with the loan provider. The obvious costs are the interest rates, but there are other costs, too — these may vary depending on the lender.
- What type of loan makes sense? Fixed interest rates are common with car loan companies and won’t change throughout the loan period. It’s more uncertain choosing a variable interest rate, as the loan provider could adjust the interest rate at any time depending on the market.
- Can I pay the loan in full early? Early payment fees should be negotiated with the loan provider just in case your situation changes throughout the loan period.
I got my car loan. What happens next?
So, you’ve finalized the deal that got you behind the driver’s seat. Now it’s time to start paying off your car loan.
If it’s an option with your lender, set up autopay to save time — and memory space — you would spend making manual repayments each month. Some lenders even offer a discount on your interest rate for signing up for automatic repayments.
Keep track of your personal account and loan balance to make sure everything’s going smoothly — sometimes, even automated systems make mistakes. Contact customer service if you notice anything amiss.
Didn’t get the loan? Find out why your application was rejected.
Prepaying your car loan: What you need to know
With many loans, you can save on interest by paying off your balance early. This isn’t always the case with car loans, however. Some lenders charge prepayment penalties, while others give you a pre-computed interest rate using what is known as the Rule of 78 formula. These loans frontload interest so that borrowers pay around two-thirds of their loan’s interest in the first few months.
In both of these cases, you don’t stand to save much by paying off your loan early. You can still lower your debt-to-income (DTI) ratio, however, which can help you qualify for other forms of financing.
Even if there isn’t a prepayment penalty and your loan comes with simple interest, be sure to call your lender to ask if there’s a special process for paying off your loan early. Also, ask if extra repayments go toward the principal — not interest. Otherwise, making extra repayments might not make much of a difference.
Car loan balloon payments
A car loan balloon payment is one large payment that’s due at the end of your loan, following smaller monthly payments. Some car loans come with balloon payments to lower your initial monthly costs without lengthening the loan term. Balloon payments are also common on auto leases.
Balloon payments can lower the monthly cost of your vehicle. But it won’t make your car loan any less expensive. And while some people might benefit, make sure you understand the risks — like going upside down or even having your car repossessed.
While balloon payments might seem like a way to make your car loan more affordable, it’s not always the case. Unless you have a lot of money coming in by the time the final payment is due, you might be faced with a bill for hundreds or thousands of dollars that can be difficult to meet.
Frequently asked questions
Answers to common questions about financing a new vehicle.
How easy is it to get a car loan?
How easy it is to qualify for a car loan depends on several factors. These include your creditworthiness, income and how much you can afford to pay for a down payment. If you have strong credit and enough disposable income to cover a down payment plus monthly repayments, getting approved isn’t difficult.
The state of the economy can also affect how easy it is to get a car loan. If the economy is poor and you work in an industry experiencing layoffs, lenders might be more cautious about offering you a car loan. On the flip side, if the economy is booming, lenders are typically less concerned about you losing your job and could be more willing to approve you with favorable rates.
How will shopping for a car loan affect my credit score?
Credit scoring systems usually count multiple auto loan inquiries within a set time frame — typically two weeks — as one. One inquiry may cause a small, temporary drop in your credit score. But it’s better than multiple inquiries.
Will I qualify for a car loan with low income?
It depends on if you’re able to prove you can pay. When you’re in this situation, you may still be able to qualify by using another asset as additional security for your loan. Or, ask your lender if you could use a cosigner.
What’s the loan-to-value (LTV) ratio on a car loan?
This is the value of your loan divided by the cash value of your car, expressed as a percentage. For example, if you got an $8,000 car loan for a $10,000 car, the LTV would be 80%.
The LTV tells you how much of the price tag your lender will cover and how much of a down payment you’re required to make. On a car loan with an 80% LTV, you’d have to make a 20% down payment.
What type of down payment do I need for a car loan?
It depends on the lender you’re applying with. Some car loan providers don’t require a down payment at all, while others will ask for anywhere from 10% to 20% of your car’s sticker price up front. Typically, your creditworthiness will determine how large of a down payment you have to make.
LEARN MORE: Compare car loan providers that don’t require a down payment
