Auto loans are one of the most common types of borrowing in the United States. However, many people do not fully understand the details of how auto loans work, even those who have gone through the process. With that in mind, here’s a rundown of what all car buyers should know before financing their next vehicle purchase.

How does an auto or auto loan work?

A car loan or car loan (the terms can be used interchangeably) refers to a type of loan that has the specific purpose of buying or refinancing a vehicle. Auto loans have three basic characteristics:

• They are secured, which means that if you don’t pay, the lender can repossess the vehicle for which the loan was used to purchase.
• They are Payment ready, which means that you will make a certain number of payments, after which the loan will be paid off in full.
• They are fixed rate loans, which means they usually have the same interest rate for the life of the loan.

Auto loans are granted by many different financial institutions. In addition to the traditional banksAuto loans can be made through online lenders, through the financing divisions of some auto companies, or through the dealerships themselves.

What credit score do you need for an auto loan?

Let us be perfectly clear. You do not need a specific credit score to obtain an auto loan. In fact, you can probably get a car loan no matter how low your credit rating is.

Having said that, your credit rating can have a huge impact on APR you can get your auto credit. To illustrate this, here are the national average rates on a 60 month new car loan and what it means if you buy a vehicle for $ 30,000:

Data source: myFICO.com. Prices as of March 4, 2020.

Here is the key to remember. Based on the numbers in the table above, a borrower with a “fair” credit score of 600 would pay $ 9,840 more in interest over the five-year term of that loan than a borrower with the credit rating level. 720+.

While it can take years to dramatically improve your credit score, it is also possible to significantly increase your score quickly. For example, if you reimburse some credit card debt, your score could jump. It might even help asking your lenders for higher credit limits – one of my favorites. credit improvement hacks.

What is the right interest rate for a car loan?

The interest rates on auto loans certainly depend on your credit score, but it is also important to realize that the interest rates as a whole fluctuate over time. Most lenders base their rates at least loosely on certain benchmark rates, such as the preferential rate or the federal funds rate, plus a premium to offset the borrower’s credit rating. When these rates change, the interest rates that a borrower of a given credit level can earn on a car loan also change.

With that in mind, you can check the current average APRs for auto loans in USA by credit score on myFICO. credit savings calculator tool to get an idea of ​​what to expect to pay, so you’ll know if a particular loan offer is appropriate or too high.

What is prequalification?

Prequalification is a valuable tool in the process of purchasing a car loan. By filling out some information with an auto lender and allowing the lender to check your credit score, you can get pre-approved for a car loan. (Note: In the mortgage world, pre-approval and prequalification have very different meanings. In auto loans, the terms are generally used interchangeably.)

This can be important for several reasons. Obviously, this tells you how much approval you can get, which can help narrow down the cars you are looking at. Plus, having a pre-qualification on hand when you walk into a dealership can be a great bargaining chip. Dealers generally want their customers to use their “favorite” lenders and are often willing to beat another lender’s rate in order to get your business.

Shop around for the best rate

On a related note, it’s also worth mentioning that one of the most important things you can do when getting a car loan is shop around.

There is a provision in the FICO formula that encourages rate shopping: all serious inquiries that take place within a two week period are treated as one inquiry. In other words, applying to a handful of lenders will have the same impact on your credit score as applying for just one loan.

Your bank or credit union is a good place to start, and it’s a good idea to have pre-approved financing on hand when you start shopping. Many dealers will match or exceed documented finance offers, so check your rates with a few lenders before you begin the buying process.

Types of auto loans

When it comes to auto credit, there are several types. Just so you understand the basic terminology:

Buy

A purchase loan is a general term for a loan obtained for the purpose of acquiring a new vehicle.

Trader

A dealership loan refers to the financing you receive through the dealership. Some dealerships work with lending partners, some use a finance division of the automaker, and other dealerships have their own finance business.

Bank

In auto loan, bank financing refers to a loan that you get from a traditional financial institution, as opposed to a car manufacturer or dealership financing program.

Refinance

A refinance loan refers to a car loan used to replace an existing loan on a car that you already own. This is commonly used when market interest rates have fallen or the borrower’s credit has improved to the point where significant savings could be made through refinancing.

Auto loan calculator

If you want to get an idea of ​​the monthly payment amount for your next auto loan, here is a calculator that can help you:

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Loan vs. lease: which is better?

Unless you are planning to buy a car with cash, you have two main choices: get a car loan to buy the car, or you can choose to lease the car. A lease is essentially a long-term rental agreement. With automobiles, leases are generally for 24 to 48 months, although shorter or longer leases are certainly possible.

Both have their pros and cons, and there is no one perfect answer for everyone. Here is a side-by-side comparison of the features of purchase and rental:

There is also your personal situation to take into consideration. For example, when my wife and I had our first child, I needed something with a bigger back seat than the car I owned before. I love cars (not big SUVs), but since we were planning on having more kids, we weren’t sure if a sedan would meet our needs beyond the next few years, so we opted to lease. . A few years later, and now that we are done having children and our family size has stabilized, I decided to buy my last car.

Be an informed consumer

Lastly, it is important to have a basic working knowledge of how auto loans work, as they are an often overlooked part of the car buying process. Knowing how car loans work, how credit scores affect auto loan interest rates, and the important steps to take before setting foot in a dealership will help you get the best car loan. possible for you.