Expert Explanation of How Auto Loans Work

With few exceptions, buying a car consists of two major activities: (1) finding the car and (2) taking out a loan to pay for it.

Understanding how car loans work, how they differ from other types of borrowing, and what you need to know to avoid getting taken for a “ride” is the business of consumer affairs expert Kathryn J. Morrison of South Dakota State University.

Dr. Morrison spoke with Investopedia recently to try to help would-be car buyers understand the sometimes confusing world of automobile loans. Our edited conversation follows:

Auto Loans vs. Personal Loans

Investopedia: How are auto loans different from other types of consumer loans, such as personal loans?

Morrison: An auto loan has collateral, meaning the value of the vehicle is the security for the lender. The lender has protection against default. In other words, if you do not make payments or default on your loan, the bank can seize the underlying asset. In this case, they can take your vehicle.

So, the big difference between auto loans and other consumer loans is that an auto loan is a secured loan that must be used to purchase a vehicle, whereas other personal loans may be used to purchase almost anything and are not secured. For this reason, interest rates on auto loans are typically lower than personal loans because the lender is taking less risk since they can seize the vehicle to cover the unpaid loan if needed. Car loans are also fixed-period loans. They are paid back over a specific period, such as three, four, or five years. Some consumer loans also have you choose a specific payback period.

Investopedia: Are loans for pre-owned cars different from new car loans and if so, how?

Morrison: A consumer should shop for an auto loan from different lenders, regardless of if the vehicle is new or pre-owned. The terms of the loan will depend on the price of the vehicle and interest rates available to you.

The simple fact that a new vehicle will cost more than an identical pre-owned vehicle will affect the amount of money borrowed. However, when purchasing a new vehicle, some manufacturers offer low, or even 0%, financing options. In general, rates on new vehicles, for these reasons, tend to be lower.

In addition, dealerships will have different financing options available, and rates and terms may vary by many factors, including new versus pre-owned. In short, it is best to look at many financing options before making a vehicle purchase and financing decision.

Lease or Buy

Investopedia: Is a lease the same as a loan? If not, how are they different?

Morrison: Leases and loans are not the same things. When you purchase a vehicle with a loan, you own the vehicle and make periodic payments against the balance of the loan. When the loan is paid off, you own the vehicle title free and clear.

When you lease a vehicle, you do not own the vehicle. Instead, you pay a monthly fee to simply rent the vehicle for a specified term under specified conditions. At the end of the term, you must return the vehicle or pay the remaining value of the vehicle known as residual value to own it. For these reasons, the monthly payment on a lease is usually lower than an auto loan. However, one must be incredibly careful in considering the lease terms, such as the maximum miles the vehicle can be driven, and if it is best to purchase the vehicle at the end of the term.

Getting Ready to Borrow

Investopedia: What information should a car buyer gather up before shopping for a loan?

Morrison: Before purchasing a vehicle, you should do plenty of research. Decide what type of vehicle you want to purchase and use an online vehicle ranking comparison tool to compare reviews and ratings of the models between which you are deciding. Make sure the vehicle meets your needs and ranks high in areas important to you, such as safety, gas mileage, and price.

Narrow your choices before stepping onto the dealership lot. Determine what options are available to you to pay for the vehicle. How much cash can you or should you put down? Use a lease versus purchase calculator to determine which option is better for you.

If an auto loan is the best option, then compare rates from various lenders such as a local bank, credit union, insurance company, and online lenders. To get an accurate idea of rates, you will need to know what your credit score is and how that will affect rates. Check your credit history from one of the three free credit reporting companies by going to AnnualCreditReport.com.

If there are any errors in your credit history, you will want to go through the process to fix those. Then, when at the dealership, see what rates and terms they have to offer, so you are ready to compare loan options. Do not be afraid to tell the dealership what rates are available to you to see if they can beat it.

You will also want to research the ownership costs of the vehicle before applying for a loan. Get an auto insurance quote from a couple of insurance companies and consider how much you will be spending on gas and maintenance each year. 

Monthly Car Payments

Investopedia: Is there a general rule for determining how much your car payment should be?

Morrison: Every individual is different, and there is not one rule-of-thumb to go by when determining how much your car payment should be. Though some will say that vehicle costs should be below 20% of your net income, much more should be taken into consideration.

What other debt do you have? What are those payments? Do you have a steady income to repay the loan, and do you have an emergency fund or savings set aside should something unforeseen happen or major vehicle repairs be necessary? Consider what your current monthly expenses are, and how adding the loan payment will affect your overall budget. Do not overextend yourself. 

Pre-approval Yes or No?

Investopedia: Should I get pre-approved for an auto loan?

Morrison: You should not get pre-approved or apply for an auto loan until you are ready to purchase the vehicle. Too many “hard inquiries” on your credit can negatively affect your score.

Instead, wait until you have done all your research and determined that a loan is your best option. Then, go to multiple lenders to see what rates and terms you qualify for. You do not need to get pre-approved to get a rate quote. Then, when you are ready, you can apply for the loan from the specific lender where you have found the best terms and rate for your situation.

Dealer Financing vs. Private Lender

Investopedia: Is it better to finance through the dealer or elsewhere (i.e., a bank or credit union)?

Morrison: As stated above, it is best to shop around. Every vehicle, scenario, and situation are different. Sometimes dealers can offer financing incentives or manufacturer terms that are better than a private lender. Other times, banks, credit unions, insurance companies, or online lenders can provide better rates.

Interest Rate Details

Investopedia: What do consumers need to know when comparing auto loan interest rates?

Morrison: When comparing auto loan rates, be sure you are comparing apples to apples. There are many things that can affect the rate of the loan. Your credit score, term (months) to repay the loan, incentives, discounts, down payment, etc. Be sure that terms and conditions are the same before making rate comparisons. 

GAP Insurance Pros and Cons

Investopedia: What is GAP insurance, and is it a good idea?

Morrison: When purchasing a new vehicle, the vehicle loses value as soon as you drive it off the lot. A new vehicle can depreciate anywhere from 10–30% within the first year alone. GAP insurance is intended to cover the difference between what you still owe on the vehicle loan and what the current, depreciated vehicle is worth.

For example, if you buy a new vehicle and finance all of it at $30,000 and get in an accident one year later, you may owe more on the vehicle than it is now worth after depreciation. A standard auto policy will cover the damaged auto at its current replacement value, but the GAP insurance will then cover the difference between that replacement value and what you still owe on the vehicle.

GAP insurance is often required on leased vehicles, and it is advised when purchasing a vehicle with little or no money down. It is also used when a consumer trades in a vehicle that has been financed, and you are bringing in the negative equity (owe more than the vehicle is worth). An auto insurance company often charges less for a GAP policy than a dealership. So again, get a couple of rate quotes before purchasing a GAP policy at the dealership.

Extended Warranties

Investopedia: What about extended warranties, undercoating, and other “finance-related” options?

Morrison: Dealerships will often offer extended warranties and added vehicle protections. Again, this is a decision that varies by person and situation. An extended warranty is essentially taking your risk of something breaking down on your vehicle and spreading that cost over the term of the warranty. So, rather than you having to pay for the repair in full when it happens, you have paid a smaller, monthly payment for the warranty to cover that if or when it occurs.

In general, I would encourage a consumer to negotiate the price of the warranty. The price that is listed in literature, or first offered, is much higher than what the salesperson or financing officer can offer you. Again, be patient, and shop around. You can always add an extended warranty later.

Rust-prevention, leather and fabric protection, undercoating, and other special dealer options are also available. Often, these services are not necessary, but again, consider your own situation and determine if you will truly find value in the service being offered at the price it is being offered at. Just make sure you know what they are selling you and know how much you are being charged for it.

Loan Terms

Investopedia: What’s the optimum period of time to finance a car?

Morrison: I keep repeating myself with this comment, but every person’s situation is different. The lower the period of time you take to repay the loan, the less overall interest you will pay on the loan. Use an online payment calculator and look at the monthly payment for each period option with the corresponding total interest paid over the life of that loan.

You will want to consider the lowest period you can afford to keep the interest costs down. However, if the rate is really low, or zero, then perhaps the lower payment and longer repayment period is the way to go.

Investopedia: When comparing loan interest rates, what do consumers need to know?

Morrison: When shopping for an auto loan, one needs to consider more than just the interest rate. Are there any additional fees that you will be charged? Do you need to have a down payment to qualify for this rate? What is the total loan amount, and how much interest will you be paying over the life of the loan?

What repayment period is required to qualify for this rate? What credit score is required to qualify for this rate? Often, the general rate quoted by banks and other lending institutions is for those with exceptional credit (credit score above 800). Be careful to get a rate quote for your specific credit score category. 

Consumer Protections

Investopedia: What protection do consumers have against an unscrupulous lender?

First, all consumers are protected under the Equal Credit Opportunity Act, which prohibits lenders from denying you credit based on race, color, religion, national origin, sex, marital status, age, or receipt of public assistance.

I would encourage a consumer that feels they have engaged with an unscrupulous lender to file a complaint using the steps outlined by the Consumer Financial Protection Bureau.

Also, anonymous tips can be filed by current or former employees or industry insiders if they believe a violation of consumer finance laws is occurring. Consumers can also use the consumer complaint database of consumer financial products, and search by state, product, issue, zip code, or company name. 

When to Refinance

Investopedia: When does it make sense to refinance an existing car loan?

Morrison: Often, if you have much of the loan yet to repay and interest rates have decreased or your credit has improved, it may make sense to refinance the loan. Use a refinancing calculator to determine if a refinance might be the best option for you but be sure to include any fees associated with refinancing the loan in your calculations. Sometimes the cost of refinancing does not outweigh the savings available.

The Impact of COVID-19 on Financing a Car

Investopedia: What has changed during COVID-19 with the process of obtaining financing for a new or used car purchase or lease?

Morrison: Auto loan applications decreased significantly early in the pandemic. However, in recent months, there has been an increase in auto loan applications. Interest rates have remained at historical lows, and with good credit, lending rates on auto loans are extremely low, due to the Fed keeping interest rates near zero.