How Do Auto Loans Work? Answers to 6 common questions

John Egan
January 27, 2018
how do auto loans work

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Learning — and understanding — all there is to know about auto loans can drive you up a wall. Things like interest rates and credit scores can be mental roadblocks when you’re in the market for a car.

First off, realize that you’re not the only passenger in the “I’m confused by auto loans” vehicle. A recent survey of 800 Americans by Instamotor, an online marketplace for buying, selling and financing used cars, reveals a broad lack of knowledge about auto loans.

Secondly, and more importantly, you can equip yourself with information so that your battery of knowledge about auto loans is fully charged. This article is designed to steer you in the right direction toward an auto loan for your new ride.

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How do auto loans work? Here are the answers to six common questions:

1. Where can I get an auto loan?

Auto loans are available from banks, credit unions, finance companies and other lenders.

In the case of a new car, a dealership often will work with a lender connected to the brand of vehicle you’re buying (at least when it comes to a new car).

For instance, automakers like Ford, GM, Honda and Toyota have their own auto-loan operations. Or a dealership might arrange your new-car or used-car loan but then sell the loan contract to a bank, credit union or finance company that’ll handle the loan and collect monthly payments.

Keep in mind that you don’t have to obtain an auto loan through a dealership. You can get a loan from your bank or credit union, for instance. But the dealership might end up being your best option.

“Major dealerships are usually able to obtain the best financing terms because they normally have dozens of lenders from which to choose, and the best of their lenders usually get a tremendous amount of loan business from them,” says Rob Drury, executive director of the Association of Christian Financial Advisors.

In fact, you’ll currently find at least six dealerships currently offering 0% financing offers on certain 2017 and 2018 models. That includes Subaru, which is offering 0% financing for up to 63 months on its 2018 Outback, and Lexus, which is offering 0% financing for up to 72 months on its ES.

But while a dealership can give you the best terms for an auto loan, such as the interest rate, that’s not always the case.

Bottom line: Don’t settle on the first loan offer you get, whether it’s from a dealership or a lender, and don’t be afraid to bargain with a dealer or lender, Gui says.

“It’s OK to say, ‘I’ll think about it,’ leave the dealership and then talk to other people to see if they can match or beat that [deal],” he says.

2. Should I shop around for an auto loan?

Yes! This can save you hundreds or even thousands of dollars in the long run.

Drury recommends shopping around before you head to the dealership to see who’s offering the best loan deals. Then, take that information to the dealership so you have some bargaining power.

“This accomplishes two things: It ensures that the buyer is obtaining the best terms, and it prevents the dealership’s finance department from increasing the interest rate excessively,” Drury says.

In the end, a dealership typically will extend a “fair and reasonable” loan offer, Drury says, because that makes it easier for the dealership to sell a car to you.

Val Gui, co-founder and chief operating officer of Instamotor, and other experts suggest getting preapproved for an auto loan through a bank, credit union or other lender before you test drive a car. Preapproval isn’t required, but Gui says it can give you an edge in negotiating the best terms for an auto loan when you’re at the dealership.

3. How will a lender decide whether I qualify for an auto loan?

Mostly, a lender will look at your credit scores. But the scores they look at aren’t the same as what you can see.

FICO, the biggest producer of credit scores, provides several versions of specific “auto” credit scores to the three major credit-reporting bureaus: Equifax, Experian and TransUnion. These specialized scores, which vary from bureau to bureau, are available to lenders but aren’t available to you, the consumer.

Auto scores differ from the scores generated for mortgage lenders and credit card issuers. At FICO, auto credit scores range from 250 (worst) to 900 (best). Basic FICO credit scores range from 300 to 850.

Gui says that while dealerships definitely do consider your auto credit scores when you apply for a loan, they’ll also examine your history in making payments on auto loans. For instance, did you make all your loan payments on time or were you late with some of them?

The federal Consumer Financial Protection Bureau suggests checking your credit reports and credit scores before applying for a loan.

By doing so, you might catch a mistake on a credit report that could harm your ability to get a loan, and then you can try to correct that mistake. Or you might notice that your credit scores are lower than you’d like them to be; you then can delay getting a loan until you’re able to raise those scores and perhaps gain a better interest rate.

4. Will my age or marital status be a factor in determining whether I qualify for an auto loan?

No. Lenders aren’t allowed to consider your age or marital status when you’re applying for auto loans.

However, about 60% of the people surveyed by Instamotor wrongly think that lenders do consider age and marital status when they’re evaluating loan applicants. If a lender does take age or marital status into account, the lender is breaking the law.

What do I need to know about the interest rate for an auto loan?

The interest rate (APR) on your auto loan is set based on the strength or weakness of your credit (primarily your credit scores), along with the length of the loan, the age of the car you’re buying and other factors.

The average rate for a new-car loan was roughly 5% in the third quarter of 2017, according to Experian. But that rate can go higher or lower depending on your credit score. The APR for a used car typically is higher than the rate for a new car.

Keep in mind that a car dealer can add interest to a loan to make more profit when you’re doing the financing through the dealership, Gui says. This is perfectly legal; about 40% of the people surveyed by Instamotor incorrectly think that practice is illegal, though.

5. How long will it take me to pay off an auto loan?

When you’re working with a lender, this is one of the things you’ll need to weigh — how much time you want to take to pay off the loan. How much money are you comfortable paying each month, and how much money are comfortable paying over the life of the loan?

According to Experian, the average new loan term for new vehicles was 69 months in the third quarter of 2017 (July through September). It was 36 months for used cars.

While some lenders offer longer loan terms, the Consumer Finance Protection Bureau cautions that although a 72- or 84-month loan reduces your monthly payments, it also stretches out the length of the loan, increases how much interest you’ll pay over the course of the loan and might come with a high interest rate.

“Cars lose value quickly once you drive off the lot,” the bureau says. “So, with longer-term financing, you could end up owing more than the car is worth.”

6. How much will my monthly payment be?

This depends on how much money you’re borrowing to buy a car, what the interest rate is and what the length of the loan is.

In the third quarter of 2017, the average monthly loan payment for a new car was roughly $500, while it was around $365 for a used car, according to Experian.

The average total for an auto loan was around $30,000 for a new vehicle and $19,000 for a used vehicle.

If you borrow $30,000 for a new vehicle at a rate of 5% over 60 months, your monthly payment would be somewhere around $566.

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