Auto Loan

An auto loan is a loan that person takes out in order to purchase a motor vehicle. Auto loans are typically structured as installment loans and are secured by the value of vehicle being purchased.

What is an Auto Loan?

An auto loan is a loan taken out in order to purchase a motor vehicle. They are typically structured as installment loans and are secured by the value of car, truck, SUV, or motorcycle being purchased.

What is a secured Loan?

An auto loan is a type of secured loan, which means that the borrower must up a valuable item to serve as collateral. If the borrower is unable to pay back the loan, the lender can then seize the collateral and sell it in order to recoup their losses. Since auto loans are used to purchases motor vehicles, the vehicle that is being purchased is what serves as collateral.

If a lender has to seize a borrower’s car due to non-payment of the loan, it is referred to as “repossession.” Until the loan is paid off, the borrower does not technically own the vehicle; the lender does. Once the loan is paid off then the borrower owns the vehicle outright. This is also sometimes referred to as owning the vehicle “free and clear.”

Secured loans are typically less risky than unsecured loans, which do not involve any form of collateral. This means that auto loans typically[1] have much lower interest rates than comparable unsecured loans, such as personal installment loans. However, a borrower’s creditworthiness (their credit score and/or credit report) will still be a factor when taking out an auto loan. The better the borrower’s credit score, the lower the interest rate they can secure.

How is an Auto Loan structured?

As with almost any loan, an auto loan consists of two distinct parts: the principal and the interest. The principal is the amount of money that is lent and is determined by the value of the vehicle. For instance, if you are using an auto loan to purchase a used truck that costs $10,000, then the principal amount for your loan would also be $10,000.

Depending on the vehicle and the dealership, there might or might not be a required down payment amount. The larger the down payment, the lower the principal of the auto loan, which means lower costs for the borrower and reduced risk for the lender. If the borrower in that example put down a $1,000 down payment on the $10,000 truck, then the amount of their auto loan would only be $9,000.

The interest on the other hand, is the amount of money that the lender is charging you on top of amount lent. It is essentially the “cost” of the loan, or how much the lender is charging you for the privilege of borrowing money. Generally, interest is expressed as an interest rate, which is a certain percentage of the principal over a certain period of time.

To return to the previous example, if that $10,000 auto loan came with a 5 percent yearly interest rate, then the loan would accrue $500 in interest over the course of a full year. An auto loan’s simple interest rate is different than its annual percentage rate or APR. The APR includes any additional fees or charges that are included in the loan beyond the simple interest rate. So when shopping for an auto loan, the APR is the best way to discover the loan’s true cost.

Auto loans are typically structured as installment loans, which means that the loan is paid off in a series of regular (usually monthly) payments. A typical auto loan will have a term that is anywhere from 36 months (3 years) to 60 months (6 years) long. The longer the loan is outstanding, the greater the amount of interest that accrues and the more the loan costs overall. However, auto loans with longer terms will usually have lower monthly payments, as each payment will represent a smaller fraction of the principal loan amount.

Most auto loans are also amortizing, which is fairly standard for installment loans. With an amortizing loan, each payment made goes towards both the principal and the interest. This ensures that every payment made goes towards paying off the amount lent. Additionally, amortization makes loans slightly cheaper; since every payment pays down the principal amount, the amount being charged in interest declines as well.

Where can I get an Auto Loan?

There are two primary ways that a person can get an auto loan. The first is to get one from a direct lender, and the second is to get one through the car dealership.[2]

With a direct lender, a person would find a car that they wanted to purchase and then go visit their bank, credit union or local finance company. They would then work with the lender to secure a loan in the amount they needed. The car would still serve as collateral and the lender would technically own the car until the loan was paid off. While this option is usually slower the dealership financing, it will also usually result in a lower interest rate, as there are fewer parties involved.

With dealership financing, the borrower can get an auto loan through the auto dealer where they are buying the car. Dealerships often has relationship with several different lenders, which means they can get multiple quotes and then select the most favorable one. This is by far the easiest and fastest option, as the borrower would not even have to leave the dealership in order to get approved. In theory—the entire car-buying process could be accomplished in a single visit. However, this option is usually more expensive, as the dealership will be making a profit off the loan, which translates to a higher interest rate for the borrower.

What is a subprime Auto Loan?

A subprime auto loan is much the same as a standard auto loan, except that is offered to people with bad credit ratings. Due to the increased risk of lending to borrowers with poor credit, subprime auto loans come with much higher interest rates than standard auto loans. They might also come with prepayment penalties, which punish borrowers who pay their loan off early.[3]

While there is nothing wrong with subprime auto loans in theory—and they do allow people with poor credit to own vehicles, which they might be able to do otherwise—subprime auto loans do carry a much higher risk of predatory business practices by the lenders. When taking out a subprime auto loan, it is always a good idea to do lots of research on a potential lender before signing their loan agreement.

What is the difference between an Auto Loan and an auto lease?

The difference between an auto loan and an auto lease is essentially the difference between renting a car and buying one. With an auto lease, the lessee agrees to rent the car for a certain period of time or a certain number of miles driven, after which they turn the car back into the dealer. Some leases do include an option to buy the car at the end of the leasing period, but many do not. The payment for leasing a car are usually less than the payments on an auto loan.[4]

However, a person who leases a car will not own the car at the end of their payment period. And while motor vehicles all depreciate in value over time, a person who purchases a car with an auto loan is likely to still own a valuable asset once they have paid off their loan. Plus, that car owner will now be free of car payments on their vehicle, while a person who leases cars will always have to make monthly payments on their vehicles.

What is the difference between an Auto Loan and a title loan?

With an auto loan, you are taking out a loan in order to purchase a car. With a title loan, you are taking out a loan against the value of a vehicle that you already down. People who do not own their vehicles will be unable to take out a title loan against.

Additionally, while almost all auto loans are structured as long-term installment loans, title loans are usually structured as short-term, month-to-month loans. In addition to the principal loan amount—which is often only 25 to 50 percent of the car’s total value—title loans come with a flat interest rate and have to be repaid in full (principal plus interest) and the end of the loan’s term.

If the borrower cannot afford to pay back the entire amount, many title lenders will give them the option to roll their loan over. This means that the borrower pays back only the interest owed on the title loan and is given another month to pay the loan back. However, they will also be charged additional interest on that additional month, which can drastically increase the cost of borrowing.

In fact, cost is one of the areas where auto loans and title loans differ. A standard auto loan will have an interest rate in the realm of 5 percent per year, whereas the average interest rate for a title loan is 25 percent per month. That adds up to 300 percent per year, making your typical title loan 60 percent more expensive than your typical auto loan. These high rates, along with loan rollover and a history of deceptive business practices and the, have led many to classify title loans as a form of “predatory lending.”

References:

  1. “What Is an Auto Loan?” KeyBank.com. Retrieved October 6, 2016 from https://www.key.com/html/what-is-an-auto-loan.html
  2. “Indirect vs Direct Auto Loans.” FinancialWeb. Retrieved October 6, 2016 from http://www.finweb.com/loans/indirect-vs-direct-auto-loans.html#axzz4MQjnJXOg
  3. “Subprime Auto Loan.” Investopedia. Retrieved October 6, 2016 from http://www.investopedia.com/terms/s/subprime_auto_loans.asp
  4. Understanding Vehicle Financing.” Federal Trade Commission: Consumer Information. Retrieved October 6, 2016 from https://www.consumer.ftc.gov/articles/0056-understanding-vehicle-financing