If you’re planning to take out a loan to buy your next car, consider shopping around before choosing a lender. This is because car loans can vary almost as much as the car you’re shopping for. Online lenders, credit unions, banks, dealerships and manufacturers all offer financing — though the rates and terms you qualify for will vary depending on your credit score, income and other factors.
There are four main types of car loans:
New car loans
Use a new car loan to purchase a vehicle directly from a dealership or manufacturer. Interest rates tend to be much lower, and you could find loan terms up to six or seven years.
But despite the lower rates, new car loans cost more. Between the larger loan amount and depreciation, you may end up owing more on your car than it’s worth.
Used car loans
When you’re buying a used car from a dealership, manufacturer or private seller, take out a used car loans. While interest rates tend to be on the high side for used cars, many borrowers may still pay less because the loan amounts are often lower than with a new car loan.
When shopping for used cars, look for cars with manufacturer warranties and certified preowned (CPO) cars to save money and protect you from unforeseen issues.
Auto loan refinancing
Refinancing gives you the opportunity to find a better rate or loan term, and it can lower your monthly payments. To refinance, you take out a new loan and use it to pay off your old car loan.
However, it may not always be worth the cost. If your income or credit hasn’t improved, or if your current lender charges multiple prepayment penalties, you might want to hold off.
If you lease your car and decide to buy it, use a lease buyout loan to purchase it from the dealership. Not every lender offers this option, but many group it with their used car loans.
A lease buyout typically works like a used car loan, so you’ll continue to make payments until the end of your loan term.
Secured vs. unsecured car loans
The majority of car loans are secured by using your car as collateral. This usually means lower rates than an unsecured loan, but you risk repossession if you default. Once you pay off your car loan, your lender is removed as a lien holder, and ownership is reverted to you.
Unsecured car loans don’t use your car as collateral. This means you don’t risk losing it if you default, but your rates are higher.
Once you figure out the type of loan you need, consider how the loan is originated.
- Direct financing. Banks, credit unions and online lenders offer financing directly to borrowers. Rather than going through the dealership, you work directly with a lender — which often means more competitive rates.
- Indirect financing. Dealerships work with outside lenders to arrange financing for their customers. You won’t apply directly with your lender. Instead, your dealership submits your information to its partner lenders to find a loan. While it’s sometimes easier, you’ll pay for the convenience with higher rates.
- In-house financing. Car loans originated by the manufacturer are referred to as in-house financing since the manufacturer backs its own loans. However, some buy-here, pay-here dealerships use this term when they offer loans directly to their customers. Just beware, as these loans typically come with higher rates and excessive fees.
Simple interest vs. precomputed interest
Depending on the car loan, interest is calculated one of two ways:
- Simple interest. Simple interest is calculated based on the outstanding loan amount. As you pay down your loan, you’ll pay less in interest. This means if you pay off your loan ahead of term, you’ll pay less overall — provided your lender doesn’t have prepayment penalties.
- Precomputed interest. Precomputed interest is calculated at the beginning of your loan and is divided evenly across your monthly repayments. Because interest is worked into the cost of your loan, paying it off early won’t technically reduce the amount you owe.
Lenders may specialize in certain types of car loans, but typically you can find financing with one of the following institutions:
- Manufacturer. Offered by most manufacturers, in-house financing is good if you have excellent credit. You’ll generally get the best rates and terms, and it could be a good way to take advantage of low rates for certified preowned cars.
- Dealership. Dealership financing is popular, but it shouldn’t be your first choice. To make money, a dealership increases your rate by a few percentage points. Consider getting prequalified for a loan before you visit the dealership so you can negotiate a lower rate.
- Bank or credit union. Most banks and credit unions offer car loans. Rates tend to be competitive, and many offer online prequalification to get an idea of what rates and terms you might qualify for before submitting a full application.
- Online lender. Many online lenders also offer car loans and refinancing. Loan amounts and interest rates are generally on par with banks. And for those with less-than-perfect credit, it may be easier to qualify.
Are auto title loans a type of car loan?
While not necessarily an auto loan, these short-term loans use your vehicle’s title as collateral. They’re available to poor-credit borrowers, which is their main draw. But with extremely high rates in the triple digits, they’re best saved as a last resort, since you risk losing your car if you default.
No matter what type of car you want to finance, a car loan can help when you don’t have the funding up front. To learn more about your options and compare potential lenders, read our guide to car loans.