Car Loans – All You Need to Know About Financing a Vehicle

Nov 27, 2016 by Smarter Loans Staff

Personal Loans Car Loans Auto Loans Vehicle Financing

Car Loans – All You Need to Know About Financing a Vehicle

Most car buyers need auto loans to purchase cars or other vehicles. Consumers who are in the market for a car should prepare themselves with accurate information about the different types of loans and where to go to apply. Credit rating and interest are also factors to consider before applying for a car loan.

Being prepared ahead of time may increase the chances of getting approval for automobile financing. In this article, we will cover the following subjects about auto loans:

How Long Can It Take to Pay Off a Car Loan?
Different Types of Automobile Loans
Where to Find Car Financing
How Credit Rating Affects Loan Approval
Understanding How Interest Works
Buying a Vehicle vs Leasing

How Long Can It Take to Pay Off a Car Loan?

Before committing to paying off an auto loan, it is a good idea to think about the time it will take to fulfill the obligation. Since most new or used vehicles are expensive, it could take years to pay off an automobile loan. Here are a few facts and figures about securing auto loans:

In 2015, the average time it took to pay off an automobile loan was 67 months-that’s five months longer than to pay off the same amount in 2010.
Today, 30% of car loans take between 72 and 84 months (six and seven years).
On average, consumers financed $28,711 for auto loans in 2015. The monthly car payment was $485. These figures set a record high for vehicle financing and payments.

Although each case is different, these figures provide a general idea of what to expect. The time to pay off an automobile loan will vary depending on several factors which will be discussed in this article.

Different Types of Automobile Loans

Car loans fall into the category of secured loans. A secured loan means that the borrower uses property as the collateral. If the debt is not paid, the lender can take back the collateral (which would be the vehicle in an auto loan).

Other types of secured loans are mortgage loans, in which the house is the secured property. With unsecured loans, If the borrower defaults (does not pay), the lender does not have property to repossess. Examples of unsecured loans are credit cards, personal loans, and retail credit. Unpaid debt from unsecured loans is usually collected by lawsuit.

Two types of vehicle loans are:

Simple Interest loans in which the rate of interest is based on how much is owed. With this type of loan, paying more than the monthly car payment saves the borrower money in the form of less interest paid. These loans are typically used to finance vehicles.
A pre-computed automobile loan is where interest and principal (the actual cost of the vehicle) are calculated and agreed upon ahead of time (rarely used since it restricts the borrower from paying off the loan earlier).
A car title loan is like the opposite of an automobile loan. With a title loan, the owner of a vehicle receives money in exchange for title to the vehicle. Car title loans are short term with extremely high interest. A borrower can lose ownership of their car if they do not pay

Where to Find Car Financing

There are several options for auto financing, such as:

Banks are a good resource for getting car loans because they often have the lowest interest rate. Getting a car loan from a bank can be easier for individuals who already have accounts with their bank, depending on their credit score.
A credit union will offer their members (only) loans to purchase a car. The rates are competitive; making them another good source to find financing.
A lot of people get car loans through the dealership where they find their vehicle. Most dealerships have credit managers who will help people find financing on the spot. Usually, the interest rate is higher than automobile loans through banks or credit unions.

Some homeowners secure home equity loans to finance their automobile purchase. The lender approves them to borrow against the equity (basically, the value of the paid portion of the home loan). There may also be tax advantages to securing a home equity loan.

How Credit Score Affects Loan Approval

Whether a borrower is applying for a secure loan or unsecured loan, their credit score will determine:

1. Whether or not the loan is approved

2. How much credit will be approved

3. The interest rate charged by the lender

If a borrower has a low credit score it can mean that any request for secured or unsecured credit is denied. Lenders may not be willing to take a risk with a borrower with bad credit. However, with creative financing that is now available, people with low credit scores can often get approval for car loans.

According to some financial experts, a credit score under 550 is considered bad credit. A higher score, around 640, is considered average. Credit in the 700+ range is rated good by most lenders. Any number over 750 puts a borrower well on their way to very good and excellent credit once the 800 mark is met.

It is always a good idea to work toward improving creditworthiness. Among the advantages to individuals with good credit are:

Their likelihood of approval is higher
They are approved for more money
The interest rate they are charged is lower

Although it is possible to buy a car with bad credit, there are financial consequences. Lenders may also require an enormous down payment, co-signer, or other terms in exchange for an approval. People with bad credit can expect a much higher rate of interest. By the time the vehicle loan is paid off, the borrower may have paid thousands of extra dollars.

Understanding How Interest Works

Interest is the money paid back in addition to the cost of the vehicle. It is the amount that lenders charge for the use of their money. The interest rate for a car loan may greatly vary, as we discussed in the section concerning how credit score affects auto loan approval. The majority of car loans are paid back with simple interest loans. Here is an example of a car payment with simple interest:

This borrower has a credit score of 598. He gets approved for a car loan through a very small car dealership with in-house financing. The car costs 10,000. His payments are spread out over 4 years. His interest rate is 20 percent. If he does not place a down payment, his first car note will be something like this:

10,000 divided by 48 months (four years) = $208.00.
20 percent interest on 10,000 is 2,000. Divided by four years of payments =$42.00/month.
Principal (the amount borrowed) $208 + $42 (interest) = First car payment of $250.33.

With this type of loan, interest is only paid on the balance owed. As the principal is reduced, so is the interest portion of the car payment. Notice the borrower is paying, over time, $2000 more than the cost of the car as interest payment to the lender.

This is just a very basic version of how a simple interest car loan can work. It is important to speak to lenders to get the exact terms and conditions of a specific auto loan, including late fees and other charges.

Buying a Vehicle vs Leasing

It is very common today for people to lease a car rather than purchase a vehicle. It is said that 30 percent of new vehicles are leased. Both options have similarities, such as monthly payments and the potential for denial if the buyer has bad credit. Some of the differences between the two options include:

With leasing, the car is never owned and must be returned at the end of the lease. When a car is purchased, the borrower eventually pays off the loan and then holds title to the vehicle.
A financed car can be traded and sometimes sold (the proceeds going to pay off the balance owed, if any). A leased car cannot be subleased, sold or traded.
The approved auto loan borrower is free to drive the car for as many miles as desired. The lessee must follow the mileage limits outlined in the leasing terms.

Conclusion

Several other factors will help a borrower decide what is exactly right for their situation when it comes to leasing a car. The best advice for consumers who need help securing auto loans, want an understanding how interest works, or to learn how credit rating affects auto loan approval, is to continue to research and ask questions before thinking of signing on the dotted line.

Smarter Loans Staff

The Smarter Loans Staff is made up of writers, researchers, journalists, business leaders and industry experts who carefully research, analyze and produce Canada's highest quality content when it comes to money matters, on behalf of Smarter Loans. While we cannot possibly name every person involved in the process, we collectively credit them as Smarter Loans Writing Staff. Our work has been featured in the Toronto Star, National Post and many other publications. Today, Smarter Loans is recognized in Canada as the go-to destination for financial education, and was named the "GPS of Fintech Lending" by the Toronto Star in 2019.