How Do Auto Loans Work: A Guide to Auto Loans in 2022
One of the benefits of auto loans, which can actually be a problem, is that they’re so easy to get.
Most auto loans are straightforward, but there are various types of auto loans that contain different provisions. If you don’t know what they are, you could end up paying too much for your loan. With this in mind, let’s go over everything you need to know to take out an auto loan as an informed consumer.
Auto loans can be ‘good debt’
Sometimes, you’ll see debates between “good debt” and “bad debt.” Good debt is usually the kind of credit taken out to improve your life. Examples include using a mortgage to purchase a home or investment property or a student loan to pay for a college education.
At the top of the list of bad debt is credit cards. Not only are they used to pay for consumption that an individual typically can’t cover with their regular income, but they also carry very high interest rates. And, since they’re revolving, they’re the type of debt that can hang around for many years.
Most good-debt-bad-debt debates either cover auto loans only lightly or ignore them entirely. In reality, auto loans can be either good debt or bad debt — it really depends on how to use them.
An auto loan is certainly bad debt if it’s used to purchase a vehicle you can’t afford or don’t really need. But, in most cases, and for most people, auto loans fall into the good category.
Having a car has become a necessity in much of the developed world, certainly for people who live in suburban or rural areas where there’s no suitable public transportation. A car provides the mobility necessary to get where you need to go, and auto loans enable you to get that car.
The main reason why auto loans are good debt
People use them to purchase cars, and cars are a necessary part of how most people earn a living. Put another way, not having a car may limit your ability to earn a living.
At a minimum, a car is often necessary to commute to a job. But if you’re self-employed, it can be even more important.
A vehicle can be an integral part of your business, without which it would be difficult to earn money. When you make the obvious connection between owning a car and earning a living, auto loans take a new and more positive direction.
Typical terms for car loans
The auto loan industry is diverse, and loan terms vary considerably from one lender to another. Auto loans typically contain something along the lines of the following terms:
- Loan amounts between $5,000 and $50,000
- Terms ranging from 24 months to 84 months (seven years)
- Interest rates from the low single digits up to well above 20% (for subprime loans)
Down payments are often the most variable component of auto loans. Many lenders will provide 100% financing, but others may require a down payment as high as 20% of the vehicle's value.
Still, others will permit you to borrow up to 120% of the “blue book value” of the vehicle, as determined by the National Automobile Dealers Association, Kelley Blue Book or another well-known auto valuation service.
You should always investigate down payment requirements before applying for a loan, particularly if you don’t have a vehicle to trade in for the down payment.
The subprime auto loan trap
You’ve doubtless seen and heard advertisements from auto dealers promising to get anyone into a car, regardless of their credit history. If you’ve ever wondered how they do it, it is through subprime auto loans.
Subprime loans are credited with causing the Mortgage Meltdown in 2008 and 2009, and they’re no longer available for mortgage financing. Similar to mortgage subprime loans, subprime auto loans charge very high interest rates.
Where you might be able to get 3.99% from a bank or credit union, a subprime loan may come at a rate of 23.99%. The very high rate compensates for the fact that the lender considers the borrower highly likely to default on the loan.
Auto dealers use subprime auto loans to get those with poor credit histories into cars. But you should only take one of these loans if you absolutely need a car, and there are no financing alternatives.
In addition to high rates, subprime auto loans frequently have the following characteristics:
- Extended loan terms: Where banks and credit unions typically make loans running three to five years, subprime loans might run six or seven years. You'll pay thousands of dollars extra in interest for the longer term.
- Add-on provisions that increase the loan amount: These may include high-cost gap insurance, credit life insurance, maintenance packages and other additions of questionable value.
- Larger down payments, such as 20%: Ironically, this substantially lowers the risk involved in the loan, but lenders don’t reflect this in the interest rate they charge.
If you do take a subprime auto loan, do whatever it takes to refinance it into a lower rate loan within one or two years. If you make your payments on time, your credit should improve enough to qualify for a much lower rate.
Prepare your credit before applying
Whether you can get approval for a loan and the rate you pay depend heavily on your credit score. Some banks and credit unions require a minimum credit score of 650 to offer an auto loan, though others may look for a higher score, such as 700 and above.
If your score is below 650, a lender will almost certainly put you into a subprime auto loan. Auto dealers work closely with subprime auto lenders. When a customer comes in who does not qualify for traditional bank financing, the dealer will set the person up with a subprime loan.
We’ve already discussed the terms of subprime auto loans, and it’s clear they’re something that you should avoid where possible. The best way to avoid having to take a subprime auto loan is to improve your credit score before applying. Raising it from, say, 620 to 660 could save you thousands of dollars in the cost of financing over several years.
Get serious about credit repair so you’re prepared for your auto loan application well in advance. Make all payments on time, dispute any errors on your credit report and pay off past due balances.
As well as your credit, lenders look at your income and the size of your down payment. Making a down payment of 10% or 20% will strengthen your credit application. And as far as income, banks and credit unions usually want to see that your total fixed monthly debts, including your new car payment, are within 40% or 45% of your stable monthly income.
Making a large down payment or buying a cheaper car than you can afford can sometimes be enough to keep you out of a subprime auto loan situation.
Auto loans vs. leases
About 25% of all new car sales are leases. For this reason, you should include auto leases in any discussion about auto loans.
Auto leases: the good
Leases have certain advantages over buying a car outright with an auto loan:
- Down payment: Technically speaking, auto leases don’t require a down payment, though most come with an equivalent arrangement referred to as a “cap cost reduction.” The reduction decreases your monthly payments and often gets satisfied by the trade-in.
- Low monthly payments: Many car dealers advertise very low monthly payments, though this is usually for leases with very low mileage allowances.
- Leases are perfect for those who want to trade in their vehicles every few years: You can take out a lease that runs for just two or three years and then replace it with a new leased vehicle.
- Warranty coverage: Since people often exchange a leased vehicle every two or three years, the manufacturer’s warranty always covers the car.
Auto leases: the bad
Auto leases have at least an equal number of potential disadvantages:
- You never own the vehicle: This means you have a liability — the lease — without ever owning the vehicle it finances.
- Nothing to trade in at the end of the lease: This means you may need to pay out of pocket to cover the cap cost reduction on the next lease.
- You can’t get out early: Actually, you often can. However, there are usually stiff financial penalties for doing so.
- Mileage limits: Monthly lease payments are closely tied to the number of miles allowed on the vehicle. The lowest monthly lease payments may limit you to no more than 6,000 miles per year.
- Maintenance penalties: Auto dealers expect you to return a vehicle in the same condition you leased it. They’ll charge you for excess wear and tear, which is often highly subjective.
- Complicated provisions: There’s no escaping the fact that lease contracts are more complicated than an outright purchase.
Auto lease arrangements work best for those who prefer to change cars every two or three years and are low-mileage drivers. If you don’t fit these criteria, a lease will cost more than a purchase.
Choosing the best auto financing company
In most cases, the best auto loan companies will be a bank or credit union, particularly one with which you already have an established relationship. This is where you’ll get the lowest rates and the best terms.
Credit unions tend to be more forgiving on lower credit scores, even those as low as 650. And since you’re a member at a credit union rather than just a customer, they’re also more likely to overlook a credit ding or two.
Some online banks also offer auto loans. A well-known example is Ally Bank.
The bank operates entirely online, and auto loans are one of its major lines of business. This makes sense given that Ally Bank is the former General Motors Acceptance Corporation. The bank has some of the industry's most innovative auto loan programs, including leases for used cars.
Once again, if your credit is not sufficient to obtain an auto loan approval from a bank or credit union, you can usually get financing from the dealer. However, something to watch for is that this is often in the form of a subprime auto loan, forcing you to pay higher interest and accept a longer term.
How to get the best rates on your car loan
Certain strategies can help get you a good deal when shopping for an auto loan.
Buy within your means
Regardless of what a lender says you can afford, keep your payment at no more than 15% of your stable monthly income. A maximum of 10% is even better. Not only will this make paying the loan easier to manage, but it will also improve the chance of your loan being approved.
Get an auto loan preapproval before shopping for a car
Apply and obtain approval before you even begin shopping for a car. Not only does this make you a more qualified buyer when you go to the dealer, but it also forces the dealer to come up with a better loan offer if it wants to provide the financing. It also prevents the dealer from steering you into a subprime loan — a practice not uncommon at certain dealerships.
Keep the loan term as short as possible
You may be tempted to go with a longer term, such as six or seven years, to keep your monthly payment low. Doing so also keeps you in debt longer and raises the possibility of your car needing major repairs while you’re still making payments.
Check your auto insurance rate before buying
Car buyers often hold off on this step until they have purchased a vehicle. But insurance rates can vary significantly from one type of car to another. If you’re interested in a certain vehicle, contact your auto insurance provider for a quote for the premium — it could be a deciding factor in whether to purchase the car.
Watch out for the loan deficiency rollover
This is an auto loan tactic used by car dealers that many car buyers are completely unaware of. It works something like this:
You’re anxious to purchase a car, but your current vehicle has a $10,000 loan on it and is only worth $8,000. You may be vaguely aware of this imbalance, but you take a shot and go to a car dealership anyway.
You’re in luck. The dealer assures you that the fact you owe more on your car than it’s worth won’t be a problem for the trade-in. You’re so ecstatic, you don’t even bother to ask why. But you absolutely do need to know how it works.
The fact that you owe more on your current vehicle than it’s worth is referred to in the auto sales business as being “upside down” on your car. As long as the dollar amount of the deficiency isn’t too high, the dealer, or more precisely, the dealer’s lender, can work with it.
How? It simply rolls the deficiency on your current car — $2,000 — into the loan on the new car you’re purchasing.
Let’s say the new car is $20,000. You don’t have any cash for a down payment, and your current car is in a negative equity situation. But the lender “fixes” the problem by issuing you a new $22,000 loan on your new $20,000 car.
Since the deficiency on your old car transfers to your new car, you’ll be upside down on your new car from the very beginning.
While it may seem like the answer to a financing prayer, this leaves you in a disadvantaged position. Since you’ll owe more on the new vehicle than it’s worth from the very beginning, it will be harder to sell or refinance. And it goes without saying that your monthly payment will be higher than if the lender hadn’t rolled the deficiency over.
Final thoughts on auto loans
If you’re in the market for a new or used car, never leave yourself at the mercy of a car dealership. Do your homework, monitor your credit, make sure you have sufficient income for the car you want to buy and investigate all auto loan options.
Update: This article has been updated to remove out-of-date information.
Disclaimer: This story was originally published on May 18, 2022, on BetterCreditBlog.org. For more information on auto loans please visit: https://money.com/get-a-car-loan/.