Auto Loan Basics

by Matt Frankel, CFP | June 3, 2019

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man sitting in car as salesman hands him the key through the window

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Auto loans are one of the most common types of borrowing in the United States. However, many people don't fully understand the details of how auto loans work, even those who have been through the process. With that in mind, here's a rundown of what all car shoppers should know before they finance their next vehicle purchase.

How does a car or auto loan work?

A car loan or auto loan (terms can be used interchangeably) refers to a type of borrowing that is for the specific purpose of buying or refinancing a vehicle. Auto loans have three basic characteristics:

  • They are secured, which means that if you don't pay, the lender can repossess the vehicle the loan was used to buy.
  • They are installment loans, which means that you will make a set number of payments, after which the loan will be repaid in full.
  • They are fixed-rate loans, which means they typically have the same interest rate for the entire duration of the loan.

Auto loans are made by many different financial institutions. In addition to traditional banks, auto loans can be made by online lenders, by the financing divisions of certain vehicle manufacturers, or by car dealers themselves.

What credit score do you need for an auto loan?

Let's be perfectly clear. You don't need a specific credit score to get an auto loan. In fact, you can probably get an auto loan no matter how low your credit score is.

Having said that, your credit score can have a huge impact on the APR you can get on your car loan. To illustrate this, here are the national average rates on a 60-month new auto loan and what this means if you're buying a $30,000 vehicle:

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FICO® Score Range Average APR Monthly Payment on $30,000, 60-month New Car Loan
720-850 4.398% $558
690-719 5.723% $576
660-689 8.04% $609
620-659 10.827% $650
590-619 15.518% $722
500-589 16.779% $742

Data source: myFICO.com. Rates as of March 4, 2020.

Here's the key takeaway. Based on the figures in the chart above, a borrower with a "fair" credit score of 600 would pay $9,840 more in interest over the five-year term of this loan than a borrower in the 720+ credit score tier. 

While it can take years to improve your credit score dramatically, it's also possible to boost your score by a significant amount quickly. For example, if you pay off some credit card debt, your score could jump. It could even help to ask your lenders for higher credit limits -- one of my favorite credit-improvement hacks.

What is a good interest rate for a car loan?

Interest rates on car loans certainly depend on your credit score, but it's also important to realize that interest rates as a whole fluctuate over time. Most lenders at least loosely base their rates on certain benchmark rates, such as the prime rate or federal funds rate, plus a premium to compensate for the borrower's credit score. When these rates change, so do the interest rates a borrower of a given credit tier can get on a car loan.

With that in mind, you can check the current U.S. average auto loan APRs by credit score on myFICO's loan savings calculator tool to get an idea of what you should expect to pay, so you'll know if a particular loan offer is appropriate or too high.

What is prequalification?

Pre-qualification is a valuable tool in the auto loan shopping process. By filling out some information with an auto lender and allowing the lender to check your credit score, you can get pre-approved for an auto loan. (Note: In the mortgage world, pre-approval and pre-qualification have very different meanings. In auto lending, the terms are generally used interchangeably.)

This can be important for a couple of reasons. Most obviously, it tells you how much you can get approved for, which can help narrow down the cars you're looking at. Additionally, having a pre-qualification in-hand when you walk into a dealership can be an excellent bargaining chip. Dealers generally want their customers to use their "preferred" lenders and are often willing to beat another lender's rate in order to get your business.

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Shop around for the best rate

On a similar note, it's also worth mentioning that one of the most important things you can do when getting a car loan is to shop around.

There's a provision in the FICO formula that encourages rate shopping: All hard inquiries that take place within a two-week period are treated as a single inquiry. In other words, applying with a handful of lenders will have the same impact on your credit score as applying for just one loan.

Your bank or credit union is a good place to start, and it's a good idea to have a financing pre-approval in your hand when you start shopping. Many dealerships will match or beat documented financing offers, so check your rates at a few lenders before you start the shopping process.

Types of car loans

When it comes to car loans, there are several different types. Just so you understand the basic terminology:

Purchase

A purchase loan is a broad term that refers to a loan obtained for the purpose of acquiring a new vehicle.

Dealer

A dealer loan refers to financing you receive through the dealership. Some dealerships work with lending partners, some use a financing division of the auto manufacturer, and other dealers have their own financing business.

Bank

In auto lending, bank financing refers to a loan that you obtain through a traditional financial institution, as opposed to through an auto manufacturer or through a dealership's own financing program.

Refinance

A refinance loan refers to an auto loan used to replace an existing loan on a car you already own. This is commonly used when market interest rates have fallen or the borrower's credit has improved to a point where significant savings could be realized by refinancing.

Auto loan calculator

If you want an idea of how much the monthly payments might be on your next auto loan, here's a calculator that can help you:

[TO BE ADDED]

Loan vs. lease: Which is best?

Unless you're planning to buy an automobile in cash, you have two main choices -- get an auto loan to buy the car, or you can choose to lease the car. A lease is essentially a long-term rental agreement. With automobiles, leases generally run for a term of 24-48 months, although shorter or longer leases are certainly possible.

Both have their advantages and disadvantages, and there's no perfect answer for everyone. Here's a side-by-side comparison of the characteristics of buying and leasing:

Auto Loan Leasing
You own the car and will own it free and clear after the loan is repaid. You have no ownership rights, and must return the car (or buy it) at the end of the lease.
You can use the car as much as you want, with no mileage restrictions. You are limited to a certain amount of driven miles, or you'll have to pay for any overage.
No charges for excessive wear and tear. You are responsible for paying for any excessive wear and tear on the vehicle at the end of the lease.
You can customize your vehicle as you see fit (within the law, of course). A leased vehicle needs to be returned in its original state, so any modifications will need to be removed.
Your car will be out of warranty after a few years, leaving you responsible for all repair costs. Leased cars are typically under factory warranty for the duration of the lease agreement, or close to it.
Monthly payment is higher than leasing in most cases. Monthly payment is lower than financing in most cases.

There's also your personal situation to take into consideration. For example, when my wife and I had our first child, I needed something with a larger back seat than the car I previously owned. I like cars (not large SUVs), but since we were planning on having more children, we didn't know for sure if a sedan would meet our needs beyond the next few years, so we chose to lease. Fast-forward a few years, and now that we're done having kids and our family size has stabilized, I decided to buy my latest car.

Be an informed consumer

As a final thought, it's important to have a basic working knowledge of how auto loans work because they are an often-overlooked part of the car-buying process. By knowing how auto loans work, how credit scores affect auto loan interest rates, and the important steps to take before you set foot in a dealership, you'll be in a strong position to get the best possible auto loan for you.

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