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How Do Car Loans Work?

You might think car loans are simple, straightforward transactions. You find a car, borrow the money, and drive home. Well, there is a little bit more to it than that.

Liens and Loan Security

When you finance a vehicle, the lender who funds your loan typically has a lien on the vehicle while you are paying it off. The financing term is typically anywhere from 24-72 months. As the lien-holder, they have a legal right to the vehicle until you’ve paid off the loan. If, for some reason, you miss payments and default on the loan, the lien gives them the right to repossess the vehicle. In this way, most car loans are “secured,” because the vehicle itself serves as a form of collateral. However, unlike a lease, there are no mileage caps and few restrictions on your use of the vehicle. Once you’ve paid off the loan, you will own the vehicle free and clear.

APR and Rate of Interest

Like most any line of credit, a car loan carries interest. This is how banks and lenders make their money:  by charging you interest. Interest rates for car loans are typically termed APR, or Annual Percentage Rate. This is typically a fixed-rate percentage that is charged on the loan. As you probably know, your APR will be based largely on your credit score. The higher your score, the lower your APR.

Approval Criteria

A lender will decide whether to approve your loan based on three main factors: credit history, down payment, and income/debt ratio. Your credit score will be one of the first things that a lender will look at. The higher it is, the better your chances of being approved are. If your credit score is low, there are plenty of institutions willing to finance you, but you may have to shop around to find them. Your credit score affects your down payment, also. The lower your credit score, the more you will need to put down. It is always wise to have 20 percent of the total purchase price as a down payment, but you may be asked for more if your score is extremely low. Lenders want to see that you can afford another payment. One way that they can assess that is looking at your total monthly payments in comparison to your gross income. This income/debt ratio should be under 35 percent.

Pre-Arranged versus Dealer-Arranged Financing

While you can simply pick out the car you want and let the dealership take care of securing financing for you, it is not always the best method. You should go to a financial institution that you have dealt with in the past and try to secure financing before you go to a dealership. The lender will tell you how much they are willing to lend to you. This will help you narrow your search to obtainable vehicles only. Dealerships secure financing with specific institutions because they are paid a commission for the business. That means you will probably pay a higher interest rate. By securing financing ahead of time, you avoid the mark up and could save hundreds of dollars over the course of your loan. Unfortunately, if you have credit challenges, your bank or credit union may be unwilling to approve you. You may want to utilize our service like ours. Apply online, and you’ll be able to speak with a finance specialist who can help you arrange financing.

Used versus New Vehicles

Car loans are available for both new and used vehicles. Used vehicles carry slightly higher APRs and, typically, must be financed for a slightly shorter period of time. Go here to learn more about how car loans for used vehicles work. New cars carry lower rates of interest, but their rate of depreciation is notoriously steep over the first year of ownership. This can cause problems like negative equity. For this reason, down payments are typically higher on new cars.

About the Author

The author has many years of experience in automotive finance and insurance. However, each consumer's situation is unique. It is best to contact a finance specialist for further assistance.
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