Auto Loan Guide

Read Time: 8 minutes

If you want to purchase a new or used vehicle but lack the cash to buy it outright, you can always try financing the transaction. This typically involves applying and getting approved for an auto loan from the dealership or a bank, credit union, or other lender.

But before committing to auto loan financing, it’s important to understand how car loans work, the interest rate you will likely pay, auto loan providers to consider, ways you can increase the likelihood of getting approved, and alternative strategies to pay for that car.

Understanding car loans

An auto loan is a financial arrangement whereby a lender provides you with the funds necessary to purchase a car. As with other types of loans, you are charged a fixed or variable interest rate on any principal amount you borrow.

You repay your principal and interest debt monthly over the specified term of the auto loan, which commonly ranges from 24 to 96 months.

“Although loan terms for new cars versus used cars may be longer – often stretching to between five and seven years – they do allow you to spread payments over an extended period, usually resulting in lower monthly payments,” explains John Wilmot, founder/CEO of LeaseLoco.

Typically, a down payment is not required to obtain an auto loan but is recommended. Experts advise aiming to put down at least 20% of a new car’s price or 10% of a used vehicle’s price if possible. The larger your down payment, the less you will pay in overall interest over the life of the loan.

“With a car loan, the vehicle itself will serve as collateral for the loan. This means that if you fail to make the repayments, the lender can repossess your vehicle to help recover any outstanding debt,” Wilmot adds.

Note that a new car you finance will typically depreciate more quickly in the early years of the loan. That means the loan balance may exceed the vehicle’s value in the first few years of financing.

“Used cars will often have already depreciated significantly in the first few years of the loan but may offer better value for the money because they’ve already experienced the biggest depreciation,” says Wilmot.

Auto loan interest rates today

Loans for new vehicles tend to have lower interest rates versus loans for used cars nowadays. Case in point: Per Experian’s most recent Automotive Finance Market quarterly report, the average car loan interest rate is currently 7.03% for new vehicles and 11.35% for used cars.

The higher your credit score (more on this later), the lower your rate will likely be; for example, expect to pay 5.61% or 7.43%, on average, for a new versus used car nowadays if you have a superprime credit score between 781 and 850.

“Lenders tend to offer better interest rates for new cars because they are considered less risky due to lower depreciation, and they have better reliability,” Wilmot says. “Interest rates tend to be higher for used cars because they are viewed as higher risk due to issues with increased wear and tear, the likelihood of maintenance, and quick depreciation. However, loan periods for used cars are often shorter, usually between three and five years.”

As a result, monthly payments for used car loans may be higher, but the total loan amount will often be less. 

The interest rate charged can vary based on factors like your loan term, credit score, lender, and market conditions.

Where Can You Get a Car Loan?

You typically have two choices when it comes to auto loan providers: You can pursue financing offered right at the dealership or through an external lender like a bank, credit union, or online lender.

“Dealership financing provides convenience, as it’s a one-stop shop for both the car and the loan,” Dennis Shishikov, adjunct professor of economics at City University of New York, says. “Sometimes, dealerships provide promotional financing deals, like cash rebates or zero percent financing for qualified buyers, especially for new vehicles. However, their rates might be higher and the loan terms less flexible compared to third-party lenders.”

Some dealerships even offer financing without a credit check involved.

“That means that people who wouldn’t qualify for a loan from a third-party lender may be able to get a loan through the dealer,” says Melanie Musson, an auto industry expert with AutoInsurance.org.

Be forewarned: While offering you a loan, the dealership may pressure you into purchasing vehicle extras, which could increase the total cost of your transaction. 

“Third-party lenders typically won’t offer you additional products or services, allowing you to focus solely on the loan,” adds Wilmot. 

Third-party banks generally offer lower and more competitive interest rates and more personalized service but may have stricter credit requirements, while credit unions are member-focused and often provide lower rates. Online lenders offer convenience and sometimes more flexible qualification criteria.

It pays to shop around among different lenders and compare loan offers and rate quotes carefully before committing to financing so that you can make a more informed decision that aligns with your budget and preferred repayment timetable.

“When considering a car loan provider, it’s important to assess your financial situation and read through all the terms and conditions before signing any agreements,” advises Wilmot. “This includes looking at your budget, credit score, and the total cost of ownership.”

How to improve your chances of getting a car loan

You’ll increase your odds of getting approved for auto loan financing if you can make yourself appear more creditworthy.

“Work on improving your credit score, because the better your credit the better your interest rate. If you are close to making it into the next credit score tier, a couple of months of good credit-building habits can make a big difference in the interest rate for which you qualify,” suggests Musson.

Aim for a credit score of at least 660, although higher credit scores of 700 or above will help secure better interest rates and loan terms.

You can improve your credit score and overall credit rating by making any debt payments on time and in full every month, paying down any outstanding balances owed, not opening any new credit accounts or lines of credit in the weeks before applying for the auto loan, and checking your free credit reports and contesting any errors or inaccuracies you spot. Just be aware that improving your score can take several months.

The lender may be more inclined to approve your loan if you make a larger down payment, too.

Other things That Make or Break qualifying for a car loan

With an auto loan, it’s essential to comprehend the conditions and terms, review the loan agreement thoroughly, and understand all the costs involved. Closing costs are not common with auto loans, but some lenders charge loan fees.

Here are some crucial fine print matters to take note of:

  • Prepayment penalties and early termination fees. “Some auto loans have penalties if you pay the loan off early or make additional payments beyond the scheduled amount. This is intended to cover the lender for any potential lost interest, so it’s worth being aware of,” says Wilmot. “Terminating the loan before the agreed-upon end date can often result in additional fees or penalties as well.”
  • Late payment fees. If you fail to make your loan payments punctually, many lenders will assess a late payment fee. The particular amount will depend on the lender and the grace period indicated in your loan agreement.
  • Administration or documentation fees. Your lender could hit you with one of these paperwork processing fees, which can vary and are sometimes negotiable.
  • Origination fees. “Some lenders will charge this fee, which covers the cost of processing the loan application, the amount of which can vary among lenders,” Wilmot adds.
  • Changing terms. Some lenders permit refinancing or modifying the loan terms, but these alterations can trigger fees or adjustments to the interest rate and vary among lenders.

“Also, remember that there are more costs for buying a car than the sticker price or the interest you will pay on the loan. You also have to pay sales tax, loan origination costs, registration, and title fees,” says Musson. “The sales tax percentage will vary based on where you live, but it will likely be the highest extra cost involved. And the various fees your lender may charge could equate to 1% to 2% of the loan value.”

Other ways to finance a new or used car

An auto loan isn’t your only option if you seek to finance a vehicle purchase. Instead, you could pursue these alternatives, if you qualify:

  • A home equity loan
  • A home equity line of credit (HELOC)
  • A personal loan

“Home equity loans and HELOCs often come with lower interest rates compared with car loans or other unsecured loans because they are secured against your home, which could make these more attractive as financing options. However, remember that using your home as collateral means that if you are unable to make repayments, that could result in foreclosure and losing your home,” Wilmot cautions. “Also, home equity loans often have longer repayment terms, so you may end up paying more interest on top of the loan.”

Pursuing an unsecured personal loan could be less risky because you won’t have to put up your home or car as collateral. But these loans tend to come with higher interest rates and shorter repayment terms, which can result in higher monthly payments.

What happens if you sell your car or your vehicle is totaled

If you plan to later sell your car but have not paid off the loan, you will be required to pay off the loan balance – often from the sale proceeds.

And if your car is totaled due to an accident or stolen, you’ll still need to pay off your loan balance. 

“In this case, your auto insurance will typically cover the market value of the car but this may not always cover the outstanding loan amount, leading to a situation known as being ‘upside down’ on the loan,” says Shirshikov. “That’s why it’s important to have supplemental GAP insurance in place, which covers the remaining amount on your auto loan if you owe more than the vehicle is worth.”

The bottom line

As with any loan, do your homework and know what you’re getting into before signing on the dotted line and getting locked into an auto loan. You stand a better chance of paying less and getting the terms you prefer if you compare lenders and loan products carefully.

Kirk Haverkamp

Kirk Haverkamp is an award-winning reporter and editor with more than 25 years of experience in journalism and public relations. He has contributed to Credit.com, Investopedia, and MetroMode online magazines, among other work. He has a B.A. in English from Hope College and a Master’s Degree in journalism from Michigan State University.

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