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 it can also be stressful trying to figure out how you’ll pay for it Getting approved for an auto loan is often the best way to make owning a vehicle more affordable,
In this complete guide, I’ll explain the most common types of car loans available. I’ll also discuss the pros and cons of each so you can make an informed decision on the best loan for your needs.
Secured vs. Unsecured Car Loans
The first thing to understand is whether a car loan is secured or unsecured.
Secured car loans require the vehicle as collateral for the loan. The lender can repossess your car if you default on the loan.
Most auto loans are secured loans. The benefits include:
- Higher loan amounts
- Easier approval
- Potentially lower interest rates
However, the lender has more control and you risk losing your vehicle if you miss payments.
Unsecured auto loans don’t use the car as collateral, They are essentially personal loans used to buy a vehicle,
The upsides are more flexibility and often an easier application process. But you’ll generally need an excellent credit score to qualify. Interest rates also tend to be higher.
New Car Loans
New car loans allow you to finance a brand new vehicle. Many people get their new car loan through the dealership to simplify the buying process. But you can also get pre-approved with a bank, credit union or online lender before shopping for a car.
Dealer financing is convenient but often more expensive. Pre-approval lets you know your budget and negotiate the best deal.
New car loans typically last 3-5 years. The down payment amount depends on the lender and your finances. Experts suggest a 20% down payment if possible.
Used Car Loans
Used car loans apply to purchasing a used or pre-owned vehicle. The process is similar – you can use dealer financing or get pre-approved for a loan.
Terms for used car loans also tend to be 3-5 years. Used vehicle loans often have higher interest rates than new cars. Providing a larger down payment can help reduce the rate.
Buy Here Pay Here Loans
Buy here pay here (BHPH) dealers specialize in financing people with poor credit. They offer in-house financing for used car purchases.
BHPH loans are infamous for high interest rates and predatory lending practices. Look for bad credit auto loans from a bank or credit union before resorting to BHPH financing.
Private Party Auto Loans
Private party loans allow you to finance a used car purchase from an individual seller rather than a dealership. Interest rates are usually a bit higher than dealer financing.
Lease Buyout Loans
A lease buyout loan covers the residual purchase price of your leased vehicle. It lets you buy and keep the car at the end of your lease term. The monthly payments may be higher than your lease was.
Auto Refinance Loans
Refinancing your auto loan means replacing your existing car loan with a new one. People often refinance to get a lower interest rate or extend the loan term.
To get the best refi rate, aim for a credit score above 670. Refinancing works best if you can reduce your rate by at least 2 percentage points.
Cash-Out Auto Refinance
In a cash-out auto refinance, you replace your loan with a new one for more than you currently owe. The extra funds get paid out to you as cash. You’re essentially borrowing against your car’s equity.
This type of refinance can provide quick access to cash. But make sure you understand the risks – your loan amount and monthly payments will increase.
Simple Interest vs. Precomputed Loans
Car loans calculate interest in two ways:
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Simple interest loans are more common. Your monthly interest is based on the remaining principal balance. Your interest decreases as the balance goes down.
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Precomputed interest loans calculate all interest upfront. Your payment equals principal, interest and fees divided evenly. Paying extra doesn’t save interest.
Simple interest loans give the most incentive to pay off your loan faster. Precomputed loans make more sense if you’ll pay as agreed over the life of the loan.
Direct vs. Indirect Auto Loans
Direct auto loans come directly from a lender instead of the dealer. Being pre-approved gives you leverage to negotiate the best financing.
With indirect loans, the dealer handles the entire financing process through their lending partners. It’s convenient but you may not get the best interest rate.
Choosing the Right Car Loan
As you can see, you have multiple options for financing a vehicle purchase. Here are a few factors to keep in mind as you decide:
- Your credit score – this impacts loan approval and interest rate
- Whether you want the dealer to handle financing or prefer being pre-approved
- If you need flexibility of an unsecured loan or the lower rates of a secured loan
- How long you plan to take to repay the loan
- Your budget and how much of a down payment you can afford
Taking the time to understand the pros and cons of different car loans will ensure you get the right financing for your situation. Just be sure to compare all the options and run the numbers before committing to a loan.
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.
Simple interest loans vs. precomputed interest auto loans
You may be offered a choice between a simple interest loan or a precomputed loan. Each type of car loan calculates interest differently, so it’s important to understand the impact of late or missed payments, as well as early payoff. In both cases, as long as you pay off the loan at the end of the full loan term, there’s usually not much difference. However, there will be a difference if you want to pay off the loan early.
| Pros | Cons | |
|---|---|---|
| Simple interest loans |
Allows for easy reduction of interest if you repay the loan early |
Large portions of your first payments go toward interest, not the principal |
| Precomputed interest loans |
You pay an equal amount of interest on each payment |
It’s hard to reduce the total cost of the loan |
In a simple interest loan, your monthly payment is calculated based on the interest rate, the balance of the loan and the daily interest accrued since the last payment. It’s the most common type of car loan in use today. Each month, your payment first goes toward interest, and the remainder pays down the principal. As a result, a higher percentage of your monthly payment goes toward interest at the beginning of your loan, and by the end of your loan term, you’re mostly paying off the principal.
A simple interest loan allows you to make additional payments in addition to the regular monthly payment so you can pay off the loan early and save on interest charges.
In this example, the car payment is always $527.05. The amount of interest you pay (in blue) decreases with each payment you make as you pay off the principal.
With a precomputed interest loan, the loan balance, origination fees and interest are calculated at the beginning and divided across the loan term. With this loan, borrowers enjoy a fixed monthly payment, fixed interest rate and rigid payment schedule. If you incur late payment fees, the percentage of your payment that goes toward the principal may be reduced to cover the fees. Monthly payments could be lower than a simple interest loan, but there’s no incentive to pay off the loan early.
In this example, the car payment is always $527.05. The amount of interest you pay (in blue) stays the same with each payment across the life of the loan.
Car Loan Interest Rates Explained (For Beginners)
FAQ
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