When it comes time to buy your next used or new car, you might not have enough cash saved to pay for it up front. That's where a car loan can help you finance this major purchase over a period of several years with payments that fit your budget. Getting a car loan, however, requires having your credit in good shape and earning a stable income, especially if you want the best loan terms and highest loan amount.
Learn more about car loans to understand how they work, which considerations to think about and how to proceed in applying with lenders.
Basics of an Auto Loan
Banks, credit unions, online lenders and dealerships all offer auto loans that help you finance a vehicle over a time period that usually ranges from three to six years. The loan amount is typically the sale price of the vehicle minus any down payment you make or trade-in value you receive for an old vehicle. The lender charges you an interest rate that normally doesn't fluctuate during the loan term and is often simple interest, meaning it doesn't compound where you'd pay interest on top of the interest your car loan has already accrued.
The lender uses your car as the security or collateral during the loan term, and your car title shows your lender's name – and may even be issued to the lender depending on the state – to reflect this. Since you don't truly own the car until you've paid off your debt, this means that if you miss too many car payments, your vehicle may be repossessed. Any missed payment, repossession or other collections action can hurt your credit for a maximum of seven years and make it harder to get financing for other things in the future.
After you've made your last car payment, you change your car title so that it no longer gives the lender any claim to the vehicle. The lender should send the title if you don't already have it, and you can visit the local department of motor vehicles with proof of payoff and title release to have the title transferred to just you. Along with the benefit of fully owning your car, the payoff and title transfer often mean you have more flexibility for car insurance coverage, as lenders typically require comprehensive coverage while the car is financed.
Reasons for Using Car Loans
Take a look at these common reasons why people consider getting a car loan for their next vehicle purchase:
- Out of necessity: The most likely reason for needing a car loan is simply not having thousands of dollars saved to pay for the vehicle and needing the car to get to work, drive to school or handle other daily errands. This can also mean that the vehicle purchase comes as a surprise because your last car broke down or was totaled in an accident, so a car loan helps get you back on the road quickly.
- To avoid draining savings: Even if you have thousands of dollars saved, you still may not want to hand it all over for a car. Otherwise, you might end up depleting your emergency fund and leaving no cushion for future issues that could arise. By taking out a car loan, you can put down some cash to reduce the loan amount but still maintain some liquidity in daily life.
- As a credit-building opportunity: While a car loan can negatively impact your credit score in the short term, as there's a hard credit inquiry and a new account with a balance added to your credit report, this step can sometimes offer advantages that make it easier to get credit in the future. If this is your first installment loan and all you have is a credit card, then the part of your credit score impacted by your credit mix could improve. Further, as you make timely payments and see the car loan amount reduced over time, you should see your credit score go up to reflect this.
- Because special offers are available: Car manufacturers often have special offers that can make financing a car seem more appealing than paying cash. For example, you can find interest rates as low as 0 percent and offers that defer payments for a few months. Keep in mind, though, that these offers usually go to people with great credit and may just apply to certain vehicle models or conditions.
Read More: The Best Auto Loan Interest Rates for 2020
Disadvantages of Using Car Loans
Here are some disadvantages of using an auto loan to buy a car:
- Car payment affordability: Like with any type of credit, getting a car loan means an extra payment each month, and this will be the case for multiple years. If your budget is already tight, this can strain you further financially and put other obligations at risk. So, it's crucial to avoid buying a car that costs more than you can afford and to negotiate with the dealership to get the best deal.
- High interest rates: While you could get a special offer with zero interest if you have good credit and get a qualifying vehicle, you could also end up with a high interest rate, especially if you have bad credit, are buying a used car or need a long loan term. This interest adds to the purchase price of the vehicle, so it's helpful to shop around for good rates and avoid vehicles that lose their value quickly. Depreciation is something to watch out for since you can end up with a loan that's higher than your car's worth.
- Down payment: If you need to finance a car due to lack of cash, hearing you need to put down a few thousand dollars to get the loan can become a roadblock. You might not need a down payment if you have good credit and a high income, but avoiding one usually means more interest and a higher loan amount.
- Qualifications to meet: Any lender looks at your credit profile and income when assessing whether you should have a car loan. If you have bad credit, however, you can expect to go through more steps, like having a larger down payment or providing references. On the other hand, lacking much income due to being retired or unemployed can also present a roadblock and make financing a car difficult.
Preparing for a Car Loan
Before moving forward to look for lenders and apply for a car loan, take some time to complete these steps so that you have the best chances of approval:
- Assess your credit: You can get free access to your credit report and score through a site like Credit Karma to better understand your credit history and current debts. Keep in mind that a credit score of 660 or higher will help you qualify for a loan without needing to seek bad credit lenders with more unfavorable terms. With a lower score, you might consider paying off other debt first or seeking alternatives to financing a car.
- Estimate your car payment: You can use online tools like the calculator from Bank of America to estimate a car payment based on the car's price, interest rate and loan term. Doing this helps you see how the new car payment would fit into your budget and better assess its affordability. For example, this tool shows that a 60-month car loan for $30,000 at a 2.59 percent interest rate would be $534 a month. If you were lucky to get the same loan with an offer for 0 percent interest, your monthly payment would be $500.
- Look at your budget: The auto lender uses your monthly income and other debt payments to calculate a debt-to-income ratio, and ideally this should be 36 percent or less to avoid too tight of a budget. You can look at your monthly budget to divide your total income by total debts (including the estimated new car payment) each month and get this number. If it's high, that's a sign to try to raise your income or pay off some debts before committing yourself to another debt payment.
Read More: What Documents Do I Need to Get a Car Loan?
Looking at Financing Options
You can now look at different financing options in your area such as car dealerships, banks, credit unions and online services that specialize in car loans. Each of these options can have pros and cons, and interest rates and financing offers vary.
For example, you could simply go to a dealership, pick a car and apply for their in-house financing program. This could help you take advantage of manufacturer financing specials if you qualify for them. But at the same time, be aware that higher interest rates and financing fees can apply for this convenient option.
On the other hand, you could have better luck getting lower interest rates at a local credit union or traditional bank, and you might find it advantageous to already have a relationship with the financial institution. If you want to handle everything online, then an online lender can be appealing, but you need to make sure they're legitimate.
Read More: How to Calculate Compound Interest on a Car Loan
Getting Preapproved for Car Loans
As you look at financing options, consider getting preapproved by at least a few of them to see the potential rates and loan amounts for which you qualify.
You can usually do this through the financial institution's website where you provide basic information like your income, expenses and desired loan amount. The lender may also ask whether you plan to buy a new or used car. There's usually be a credit check at this step, but you don't need to commit yourself to buying a car or even taking the loan if it's approved.
You should get a document to print out that gives your estimated interest rate and loan amount, and you can compare the results from multiple lenders. You can choose the lender with the best terms and bring the preapproval letter with you to the dealership.
Purchasing and Financing Your Car
With your preapproval letter in hand, you can start looking for a new or used car that fits the loan amount offered. Once you've found a car at a dealership and you're ready to move forward with the purchase, you can start filling out the official car loan application through the chosen lender. If you opt for dealership financing, this usually happens when you're there to complete the other paperwork to get the car. Otherwise, you may complete the application online beforehand or call the lender if you're using external financing.
In any case, you can expect to present documents to the lender verifying your income, identity and residency. For example, this can include tax returns and W-2 forms for income, a driver's license or passport for identity and utility bills for residency. Depending on the lender, these may be presented in person or uploaded through an online platform.
Once you get official car loan approval, you can move forward with completing the other paperwork needed to finalize the car purchase. When using external financing, the dealership typically requires that you bring financing paperwork with you at this step. You can expect to fill out a purchase contract, title and registration documents and other items related to insurance and any extra services you've accepted with the car purchase.
Read More: Cheapest Way to Buy a Car
Handling Car Loan Approval Challenges
If your car loan approval falls through, or you have issues getting lenders to offer you good terms, you can consider these options and alternatives:
- If you lack sufficient income or good credit history, find a friend or family member who acts as a co-signer for your auto loan.
- Try to make a larger down payment to compensate for a lower income or poor credit score, but do keep in mind the higher interest you might pay.
- Consider bad credit lenders if you desperately need a car and have no other option, as these lenders are more willing to accept the risk in exchange for less favorable terms for you.
- Consider leasing as an alternative to buying if you want to avoid a high down payment, you'd prefer lower monthly payments and you like to switch vehicles every few years.
- Bank of America: How Car Loans Work
- Credit Karma: Car Repossession: What Is It and How Will It Affect My Credit?
- Credit Karma: What Is Financing a Car?
- NerdWallet: Does a Car Loan Help My Credit Score?
- AutoBytel: Disadvantages to Financing a Car
- CarsDirect: Basic Car Loan Requirements
- LendingTree: Debt-to-Income Ratio for Car Loans: What to Know
- Bank of America: Estimate Your Monthly Car Loan Payment
- Credit Karma: Applying for an Auto Loan: What You Need To Know
- U.S. Bank: Apply for Pre-Approval for an Auto Loan
- FTC: Financing or Leasing a Car
Ashley Donohoe has written about business and technology topics since 2010. Having a Master of Business Administration degree, bookkeeping certification and experience running a small business and doing tax returns, she is knowledgeable about the tax issues individuals and businesses face. Other places featuring her business writing include Zacks, JobHero, LoveToKnow, Bizfluent, Chron and Study.com.