Car buyers have several choices in types of car loans for financing their next vehicle purchase. Some are more common than others, but it’s helpful to know about the different types of car loans that you may come across as you shop for your next vehicle.
The main differences in the types of auto loans are whether the vehicle is used as collateral, the way the interest is calculated and the source of financing. There are also special types of auto loans for special circumstances.
Buying a car is an exciting experience, but financing it can be confusing with all the different types of auto loans available. As an experienced car buyer, I want to walk you through the most common types of car loans, so you can make an informed decision on the best loan for your needs.
After researching the latest information from top financial websites like LendingTree and Bankrate. I’ve discovered there are 5 main categories of auto loans
- Secured vs Unsecured
- Simple Interest vs Precomputed Interest
- Direct vs Indirect
- Prequalification vs Preapproval
- Specialty Auto Loans
Understanding the key differences between these loan types will save you money and headaches down the road. Let’s dive in!
Secured vs Unsecured Auto Loans
The first decision is whether you want a secured or unsecured auto loan.
Secured loans use the car itself as collateral for the loan. The lender places a lien on the title, so if you default they can repossess the car.
Unsecured loans have no collateral tied to them. If you default, the lender must take legal action to get repayment.
Here’s a comparison of their pros and cons:
Secured Auto Loan
Pros:
- Lower interest rates and overall loan cost
- Lender can repossess car if payments stop
Cons:
- Car must meet lender requirements to qualify as collateral
Unsecured Auto Loan
Pros:
- No restrictions on how loan is used
Cons:
- Higher interest rates than secured loans
- No collateral if borrower defaults
Over 90% of auto loans are secured because it gives lenders more protection. But unsecured personal loans can be a good option for older, high mileage, or specialty vehicles that don’t qualify for traditional secured financing.
Simple Interest vs Precomputed Interest
The next decision is how interest accrues on your loan – simple or precomputed.
Simple interest loans calculate interest monthly based on the outstanding principal balance. Your payments go mostly to interest early on, and toward principal later in the loan.
Precomputed loans calculate all interest upfront. Your payment stays the same each month even as the principal declines.
Here’s how they compare:
Simple Interest Loan
Pros:
- Paying early saves interest since it’s calculated monthly
Cons:
- More interest paid early in loan term
Precomputed Interest Loan
Pros:
- Equal interest payment each month
Cons:
- No incentive to pay off early since interest is fixed
Over 70% of auto loans use simple interest because it rewards early repayment. But some people like the predictable payments of precomputed loans.
Direct vs Indirect Auto Financing
You can get financing directly from a lender like a bank or credit union. Or indirectly through a car dealership.
Direct lending involves applying directly to potential lenders. You control the process.
Indirect lending goes through the dealer who shops your application to lenders. This can be faster but you have less control.
Here’s how they stack up:
Direct Auto Financing
Pros:
- You see all loan offers extended to you
- Can negotiate from position of strength with rate in hand
Cons:
- Applying to multiple lenders takes more time
Indirect Auto Financing
Pros:
- Faster since dealer shops application to many lenders
Cons:
- Dealer controls which loan offers you see
- Dealer can markup rates without borrower’s knowledge
I recommend getting preapproved yourself first, so you can compare direct loan offers with the dealer’s indirect ones. This helps ensure you get the best rate.
Prequalification vs Preapproval for Auto Loans
Prequalification and preapproval sound similar but have different implications when financing a car.
Prequalification is a quick, soft credit check estimating your chances of approval.
Preapproval is a formal approval subject to final underwriting. It requires a hard credit check.
Here are the key differences:
Prequalification
- Soft credit check won’t hurt your credit score
- No guarantee of final approval
- Interest rate not locked in
Preapproval
- Hard credit check will temporarily lower credit score
- Essentially guaranteed financing
- Loan terms are locked in
I suggest getting preapproved to show sellers you’re a serious, qualified buyer. Just beware it involves a hard credit check.
Specialty Auto Loan Programs
Beyond those main categories, some special auto loans serve specific borrower situations.
1. Military Auto Loans – Special terms and discounts for active duty and veterans. Offered by lenders like Navy Federal Credit Union.
2. Buy Here Pay Here Loans – For borrowers with poor credit. Car dealer provides financing. Higher rates and risk of repossession.
3. Title Loans – Secured loan using car title as collateral. Extremely high interest rates, like 300% APR. High repossession risk. Generally a bad idea.
4. Low Income Auto Loans – Special programs help lower income buyers qualify for affordable financing. Offered by non-profits and some manufacturers.
5. Student Auto Loans – Designed for college students with little credit history. Usually require a cosigner. Offered by some lenders.
The right specialty loan can help you drive away happy. Just read the fine print to avoid unfavorable terms.
Choose the Best Auto Loan for You
Secured, simple interest loans offered directly by lenders are the most common. But don’t rule out alternate options that may better suit your credit profile and financial situation.
The most important thing is doing your research upfront, so lucrative incentives don’t blindside you in the finance office. Knowledge is power when it comes to auto financing.
Direct auto financing vs. indirect auto financing
Direct financing is when you obtain a loan by interacting directly with the lender, like a bank or credit union. Indirect financing is when there’s an intermediary between you and the lender, like a car dealership. Most consumer auto lenders are both direct and indirect lenders. You can obtain an auto loan from them by applying directly or going through a dealership. There are some pros and cons to each type of relationship.
| Pros | Cons | |
|---|---|---|
| Direct financing |
Access to loan offers without a third party filtering the information |
Separate applications for each lender can take time and effort |
| Indirect financing |
Receive multiple offers by filling out one form |
You may not see every offer you receive, and dealerships have the ability to raise your APR |
With direct financing, all communication is done directly between lender and borrower. You won’t have the dealer filtering information.
You can find direct financing through a bank, credit union or online lender. It’s often a good idea to apply to lenders directly to secure your own financing before you go to the car dealership. The interest rate you are offered will be based on your credit score and payment history. With that knowledge, you can compare the financing offers from the dealer to make sure you’re getting the best rate for you.
Dealer-arranged financing is a common form of indirect financing. The dealer’s finance office can shop your application among some of the same lenders you can go to directly. It will also submit your application to its captive finance company, such as Toyota Financial Services.
While many buyers like the simplicity of indirect financing, be aware that dealers may increase customers’ APRs and pocket the difference between the rate you agree to and the rate you actually qualify for. The dealer may not always show you the best offer for your budget.
Although prequalification and preapproval sound very similar, they are two different things. The difference is based on the lender’s commitment to providing financing for you and your level of interest in getting financing for a car loan. We highly recommend getting preapproved for an auto loan before you visit a dealership.
| Prequalification | Preapproval |
|---|---|
|
|
Prequalification is simpler and faster and is based on your annual income and how much other debt you already have. The lender may also consider your credit score to let you know if it’s likely you’ll qualify for the loan amount you are seeking. Banks will perform a soft pull on your credit for a prequalification, which won’t impact your credit score. A prequalification is not a guarantee of financing approval or an offered APR.
Preapproval represents more of a commitment from the lender that they will provide an auto loan for the amount you need. The lender reviews your credit score and verifies income and debt levels. It’s still not a guarantee you will get the loan, but it provides you and the auto seller with a high level of confidence that you will receive the financing you need. The preapproval is based on the loan amount, interest rate and loan term so you have a solid picture of what your payments will be.
A preapproval requires a hard pull or full inquiry on your credit, which could temporarily lower your credit rating by a few points. However, if you’re shopping for a car, you can have multiple hard pulls within 14 days that are treated as a single pull for your credit rating. With LendingTree, you can receive up to five car loan offers by filling out a single form.
Secured auto loans vs. unsecured auto loans
There are two types of auto loans: secured or unsecured. For a secured loan, the lender puts a lien on the vehicle that is being purchased. Other types of secured loans will put a lien on other collateral owned by the borrower, such as a house or another vehicle. If payments are not made, the lender may repossess and sell the asset to recover money to pay off the loan balance. It’s important for borrowers to understand which assets are secured by a loan and are therefore subject to repossession.
An unsecured loan, on the other hand, is not tied to any assets. If payments are missed, the lender has to pursue payment from the borrower through other legal means. That’s why unsecured loans typically come with higher fees and interest rates.
| Pros | Cons | |
|---|---|---|
| Secured auto loans |
Lower finance charge Lower overall loan cost |
Potential for asset repossession for nonpayment Asset used to secure the loan must meet lender requirements |
| Unsecured auto loans |
No restrictions on how you use the money |
Higher finance charge |
Secured auto loans are the most common type of car loan for new and used vehicles. The loan is secured by a lien on the vehicle, and the title can’t be transferred without satisfying or paying off the lien. If you fall behind on the payments, the lender can repossess the vehicle and sell it to recover the money owed on the loan.
Traditional auto loans: A secured auto loan is the type of car loan you will be offered by banks and credit unions. Because the loan is tied to the vehicle, secured auto loans typically have the most attractive APR rates and terms. The best interest rates go to those who have an excellent credit rating. Many auto manufacturers have captive auto financing companies — such as Ford Credit or Honda Financial Services — and offer incentive rates on new and certified pre-owned cars. Traditional auto loans can be used for:
- New cars: You’ll typically find the lowest rates for the newest cars.
- Used cars: The older the car, the higher the interest rate will probably be. “Used” could apply to a car that’s only a month old, including certified pre-owned (CPO) cars.
Balloon loans: This secured car loan has a unique payment structure. Balloon auto loans feature relatively small payments for the first few years of the loan and then a large final payment at the end, which is often thousands or even tens of thousands of dollars. When the loan “balloons,” you could make the large final payment, trade the car in for another one or sell it and pay off the loan.
Business and fleet auto loans: Businesses buy cars and trucks with commercial-level financing because the vehicles may not qualify for traditional auto loans. There are a number of options for financing business or fleet vehicles:
Personal loans, credit card debt, personal lines of credit and student loans are all types of unsecured debt. They aren’t linked to any asset that could be repossessed. There are fewer restrictions on how the money is used, so it could be a good option for a car that doesn’t fit the traditional mold. Review personal loan lender options with LendingTree to determine whether this is a smart financial decision.
This type of car loan could be attractive if you’re buying an inexpensive car with a price below the minimum for traditional bank financing. For example, Capital One has a $4,000 minimum for an auto loan.
An unsecured loan could also be an option if you’re buying an old car or collector car that doesn’t qualify as collateral for secured financing. Lenders often have restrictions on the age and mileage for a car to serve as collateral. Bank of America, for example, will only finance cars that are 10 model years old or newer and have less than 125,000 miles on the odometer.
Car Loan Interest Rates Explained (For Beginners)
What are the different types of car loan types?
Car loan types differ by: 1. New Car Loan When you buy a new car, you can buy it with cash, a lease, or a car loan. Lenders such as banks, credit unions, online lenders, and finance companies will look at your credit history and credit application to decide whether to approve or deny you for the loan.
What is an auto loan?
An auto loan is a type of secured loan for purchasing a car or other vehicle. The vehicle itself serves as collateral for the loan and can be repossessed by the lender if the borrower defaults. Auto loans today come in many different terms, or lengths, typically ranging from 36 to 72 months, but sometimes up to 96 months.
What are the most common car loan terms?
The most common auto loan terms are 24, 36, 48, 60, 72 and 84 months. NerdWallet recommends avoiding long car loan terms if possible, limiting new cars to 60 months and used cars to 36. Going with a longer term loan may result in a lower monthly payment, but you will pay more in interest over the life of the loan.
What is a used car loan?
A used car loan is actually just like a new car loan, except the purchase is for a used car. Note that when you purchase a used car, the loan terms may not be as favorable because the vehicle itself is not as valuable. This is particularly important for secured loans, which are next on the list. 3. Secured Car Loan