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How Do Car Loans Work? Auto Loan Basics

How Do Car Loans Work? Auto Loan Basics
Alyssa Schwartz

Alyssa Schwartz

Updated December 2, 2021
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
Buying a car is one of the biggest purchases most people make. And with average prices in the tens of thousands, it’s a financial move that often requires financing or a loan. Given high auto prices, it’s no surprise that people are borrowing more money than ever for their wheels — Americans have a combined $1.37 billion in auto debt. Indeed, borrowing money to cover the cost of a car is very common. Whether learning the generalities of what is an auto loan or the specifics of how bank car loans work, there is information that can help, as well as a few options to be aware of when it comes to financing a vehicle.

What Is a Car Loan?

First the basics. What is a car loan? Similar to other types of loans, getting a car loan means borrowing money from a lender, but specifically to cover the cost of buying a car.There are various options and lenders available when looking for an auto loan: directly from the dealership, from a bank, or, if purchasing from an individual, a private party auto loan.

How Do Auto Loans Work?

Car loans function similarly to other types of loans in that the borrower agrees to repay the amount borrowed over time, as outlined in the loan agreement. The amount of money that needs to be repaid includes the principal, interest, and any applicable fees. One big difference between car loans and other types of loans is that borrowing money for a car almost always involves car loan collateral. While other loans may be either secured or unsecured, car loans typically are secured by the auto itself. In the event that the borrower can’t repay the loan, this leaves the lender with the ability to recoup that money via car repossession.Auto loans are based on simple interest and do not compound. Even so, with the average car loan length coming in just shy of 72 months — six years — according to Experian, it’s worth noting that the longer the amortization period, the greater the interest charges will be, even if monthly payments are lower with longer loan terms.Shorter loan terms may also have lower interest on a car loan than 60-month terms or longer, further increasing potential car loan savings. This is because the longer the auto loan term, the riskier the lender deems it to be.

What Types of Lenders Offer Car Loans?

Before a car buyer drives home with their new car, they’ll first have to obtain a loan if they plan to finance the purchase. This is commonly done through the car dealer, a bank, or a private lender. There are pros and cons to each option.

Banks

Qualifying for a bank car loan usually starts with a credit check. And as with other types of loans, an individual with a high credit score is more likely to be approved and may pay lower interest because they are considered to be at a lower risk of defaulting than an individual with a low credit score.Even if someone is concerned they don’t have the credit score needed to buy a car, it’s still worth applying, as a bank may allow a cosigner or offer a loan at a higher APR to account for the added risk. However, if someone is concerned about their score, they may want to prequalify for a loan to get an idea of their chances minus the hit of a hard credit check.A bank will also likely want to see employment and income details as well as a government-issued ID and proof of address. Some banks will also require information about the car the borrower wants to purchase.Some banks also offer car loan preapproval, which gives the borrower an idea of the amount of money they are eligible to borrow. This can be helpful information during car shopping because the buyer will have a better idea of their budget.

Dealerships

A car dealer has a vested interest in the car purchase. After all, if the prospective buyer needs financing but is unable to get a car loan, the dealer won’t make the sale and won’t get paid. Documents required to qualify for dealer financing are generally the same as those required for bank financing: proof of employment, income, and residence. Vehicle information will, of course, already be known. There are situations where this may work in the car buyer’s favor. For example, if the dealer has a lot of cars they need to sell, or have been falling short of sales quotas, they may be inclined to reduce interest rates or offer low or 0% interest financing to incentivize buyers.Given that the average APR for a 60-month new car loan at commercial banks was 4.6% in the third quarter of 2021, according to data from the Federal Reserve, the savings associated with such a promotion can be substantial. For a 60-month car loan to pay for an average-priced new car — $40,768 — the total paid over the term of the loan would be $45,714, including $4,946 in interest based on the average APR (not including any additional fees or taxes or accounting for a down payment).Dealers may also offer greater financing flexibility, which can be a double-edged sword. They may be more likely to extend a loan to someone whose credit score would disqualify them at the bank and might encourage a longer loan term to make monthly payments more affordable. But this may increase the risk of default for some individuals.

Private Lenders

Some car buyers might not want to use bank or dealer financing, but still need some sort of loan to buy a car. If buying a used car, neither bank or dealer financing might be available. Financing through a private lender can be another option to consider.A private lender might be a friend or family member. If that’s not an option, peer-to-peer (P2P) lending might be something to look into. P2P lending matches two individuals: one that has money to lend and one that needs a loan. People who might not have the creditworthiness to qualify for a loan from a bank or dealership might be able to qualify for a P2P loan, as they sometimes have more flexible qualification requirements. Shorter credit histories or credit scores that are just “fair” might qualify for a P2P loan, whereas those might be cause for denial of a traditional auto loan.

What Happens if an Auto Loan Is Not Paid Back?

Defaulting on any type of loan can negatively affect your credit score. Defaulting on a secured auto loan (or any secured loan, for that matter) means the lender can also initiate car repossession because the car was used as collateral. Talking to your lender when you realize you’re going to have trouble making your auto loan payments is a good first step to take. Some lenders might have debt relief options, such as skipping a few payments or refinancing the loan, for example. Some lenders might allow someone else to take over the payments on your loan. Having someone assume your loan typically requires similar documentation from that person as the original borrower provided when initially applying for the loan. The lender will want to make sure the new borrower will be able to make the payments.

Car Loan Alternatives

Taking out a large loan to purchase a new car is not the only way to obtain a form of transportation. There are options to consider, such as:
  • Saving up to buy the car with cash.
  • Save up a larger down payment so the amount financed is less.
  • Buying an affordable used car rather than a new car.
  • Leasing a car instead of buying a car.
  • Using home equity to finance a car.
  • Get a personal loan
Finding ways to make a car more affordable, regardless of financing, might be negotiating the price of the car, negotiating the trade-in value of the car you’re replacing (if that applies), or determining if any offered add-ons (e.g., extended warranty or service contract) are really worth the extra cost. Know what you are able to afford and don’t be afraid to walk away from a sales person if you can’t come to an agreement.

The Takeaway

Whether you plan to use a car for weekends away and shopping trips, or it’s a must for the daily commute, it’s likely to be a costly purchase. If a vehicle purchase is necessary, finding the best car for your circumstances at a cost you can afford is an important part of your financial plan.If you already have a car loan, but are looking for refinancing options, Lantern by SoFi can help you compare rates and find the best option that works for your financial situation. Prequalification takes just minutes and checking auto refinance rates comes with no obligation to continue.Learn more about auto loan refinancing at Lantern by SoFi
Photo credit: iStock/Hispanolistic
SoFi Loan Products SoFi loans are originated by SoFi Lending Corp (dba SoFi), a lender licensed by the Department of Business Oversight under the California Financing Law, license # 6054612; NMLS # 1121636. For additional product-specific legal and licensing information, see SoFi.com/legal.*To check the rates and terms you may qualify for, SoFi conducts a soft credit pull that will not affect your credit score. A hard credit pull, which may impact your credit score, is required if you apply for a SoFi product after being pre-qualified.SOLC1021232

About the Author

Alyssa Schwartz

Alyssa Schwartz

Alyssa Schwartz is a freelance writer who writes about personal finance, lifestyle, and other topics.
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