Buying a new car is a significant investment. It’s likely one that you want to finance.
The process of getting a car loan can be overwhelming. All the jargon, complicated clauses, and the multitude of options available can be hard to understand. You may even be wondering if you qualify and what you’ll need to apply.
Knowing what to expect in advance can save you headaches, time, and money.
Here are nine frequently asked questions about car loans.
Frequently Asked Questions About Car Loans
1. What is a car loan?
A car loan is a sum of money you borrow from a lender to buy a car. You can’t use it for anything else.
The vehicle you purchase will automatically become the collateral for the loan. Should you fail to repay, the lender will seize your car to recover outstanding funds. Your lender retains ownership over the vehicle until you make your final payment.
Repayments are fixed installments paid monthly for the duration of the loan.
2. How do car loans work?
Car loans aren’t much different from other types of loans. They follow most of the same procedures. So if you’re ready to purchase a car, you’ll need to apply for a loan ahead of time. When your lender approves your application, they’ll tell you the maximum amount you’re able to borrow.
You can use the maximum sum or less based on your car preference and budget. Don’t go overboard just because a lender gave you a larger loan ceiling than expected. Repayment is still on the table.
Once your lender calculates the interest, you’ll see the total repayment sum broken down by the length of repayment (36-72 months) to assign your monthly installments.
The total loan amount also includes fees and taxes.
3. What documents do I need when applying for a car loan?
The first bit of paperwork you require is a form provided by your lender. They will ask for recent financial information if you apply with your local bank or credit union.
Required information includes proof of monthly income and employment in the form of payslips. If you are self-employed, your tax return and bank statements can stand as evidence of a consistent income.
Lenders will deep dive into your financial history, checking your credit report. Your credit report details all of your past borrowing activities and if you currently have any outstanding debts. Your credit score, calculated based on the details in the report, will be a top eligibility factor for your application.
Another major hurdle is your debt-to-income ratio (DTI)—how much of your earnings goes towards repaying debt. It’s a standard risk assessment for lenders before approving loan payouts. Your lender wants to know if you can manage the payments for the loan they offer.
If you have a poor reputation for paying your loans on time, in full, or at all, you may either pay a high-interest rate as a high-risk client, or you won’t qualify for a loan.
Some lenders will require particular documents that others do not. Phone ahead to ensure you have all the materials you need. Submitting all the correct documents with your initial application will speed up the approval process.
Here’s a list of some documents you may require:
- Proof of identity
- Current driver’s license
- Proof of Income and Employment (bank and tax statements if you are self-employed)
- Proof of current residence (utility bill or other business correspondence)
- Proof of Insurance
- Vehicle information
4. How can I apply for a car loan?
Step #1: Educate yourself
Learn as much as you can about car loans before applying for one. When you know what to expect, you can set realistic expectations for your budget and the chance of approval for the loan amount you require.
Always be prepared beforehand for financial investments, no matter what they are.
Step #2: Determine what you can afford
Part of the application process is noting the amount of money you’d like to borrow. Dream according to your budget. It’s not a defeatist approach to acquiring your vehicle; it’s a smart one.
You don’t want to fall into debt with your monthly payments. And on top of that, you still have to consider the initial down payment and ongoing expenses.
Step #3: Check your credit score
While calculating your wallet’s buying power, check your credit’s trust factor. Lenders judge if you’re a safe bet based on your credit history. If you’re a constant defaulter, have any loans in arrears, or are currently in repayment, you may lose some favor.
“Losing favor” reflects in your interest rate and the terms of your loan contract. The higher your credit score, the better your chances of locking in a low rate and preferential conditions.
Step #4: Shop around for the best loan deal
You’re in good standing right across the board if you have a good credit score. Lenders will love you and approve your loan faster and with better terms. But if you don’t, shopping around will be your saving grace.
Some lenders specialize in offering car loans to borrowers with bad credit. Some of these lenders, however, may try to take advantage of your situation. Watch out for the scammers and weigh your options before signing any contracts.
Terms and rates will vary across lenders, invest the time, and do your research.
Step #5: Apply for a loan
After sorting out your finances and the necessary documents, it’s time to apply. Once your loan is pre-approved, you’ll know the exact amount you’re able to borrow.
Banks and credit unions are the best choices for pre-approved loans.
Avoid “conditional” and “contingent” loans where you sign a loan agreement with a dealer before all the details like down payment, interest rates, loan period, etc., are finalized.
Sure, they allow you to drive away with your car sooner, but they can come with nasty surprises. The terms may leave you at an unexpected disadvantage.
Always know what you’re in for before signing any loan agreement.
Step #6: Time to shop for a car
As you did with your lender, shop for the best car prices. While doing so, check out car dealers’ interest rates for their in-house financing.
Compare their offering to your pre-approved offer and see if the dealer can beat the price and terms. Even if you’re not interested in switching lenders, let your dealer know about your preapproval for a loan.
A pre-approved loan means that you are a “cash buyer.” You can negotiate the car’s overall price, not the monthly repayment.
Once you’ve settled on the car you want to purchase, update your lender with the desired vehicle’s make, model, year, and Vehicle Identification Number (VIN).
After you’ve completed these six steps, there is the seventh step. Step #7 is the timely repayment of your loan. As we’ll discuss later, defaulting on your car loan can severely affect your credit score.
5. How are car loans approved?
Lenders look at four criteria when deciding if they want to work with you.
- Applicant information. Your lender will verify all the information you provide with your application. Based on the results, you either be a high or low-risk client. Where you fall on their scale will determine your loan terms and conditions.
- Vehicle selection. The cost of the car, its age, and mileage if you’re purchasing a used car, all factor into the final decision. New vehicles tend to receive better interest rate preferences.
- Credit history. Your credit history is an unavoidable factor. It’s the financial footprints lenders follow to find any debt skeletons in your closet.
- Down payment. Lower loan amounts pose less risk to lenders. Large down payments usually reap generous interest rates.
6. How are car loans calculated?
Car loans are calculated based on the principal (the amount you borrowed) multiplied by the given interest rate of your lender. Your monthly loan installment is calculated by dividing the final payment by the payment period. These periods can range from 36 to 48 months, all the way up to 72 months.
Be mindful of loans you see with low-interest rates and long repayment periods. They may seem attractive with small monthly installments, but when you calculate it, the length of the loan accumulates more funds than one with a shorter term.
Let’s use Bankrate to work out some estimates for a loan of $20,000 borrowed over a 36, 48, and 72-month period.
Total Cost for each Loan
36 months: $20,938
42 months: $21,249
72 months: $21,879
Whatever payment period you choose comes down to your financial situation. Do you want to get rid of your debt as soon as possible? Is the difference for the extended period compared to the shorter a reasonable loss for low monthly payments?
Consider all this before stepping into a dealership or bank. Online loan calculators like the one we used from Bankrate can give you estimated ballparks for the monies you’re likely to pay.
7. Will a car loan affect my credit score?
Your credit score plays an enormous role in all your financial transactions. Car loans included. Depending on where your score falls on the scale from poor, fair, good to excellent, your interest rate can range from 4% to 12%. The better your score, the lower your rates.
Every time you take out a loan or apply for insurance, it reflects in your score. If you default on payments or have multiple open loans at once, your number will take a hit.
Applying for a car loan may shave a few points off your credit score with the right credit mix, but the effect is temporary. That is if you meet your monthly payments in full. Paying on time every time will boost your credit score as you get points for being financially responsible.
Errors, however, can screw things up, so you need to always be on top of your payments and check your credit history for discrepancies. If you make a payment on time and it’s posted late to your account, this will raise a red flag. In cases like these, file a dispute immediately. And the only way you can do that is by reviewing your information every month.
8. Can I get a car loan with bad credit?
There are auto loans for every credit situation, but another matter is whether the terms will be favorable. A bad credit score often leads to higher interest rates.
With a score of 600 and below, lenders will wonder if they’ll get their money back. Will they have to come knocking at your door at the end of the month and demand payment? It’s a hassle and a loss they don’t want to get stuck with, so they’ll make you pay for it in interest.
You can spin a silver lining into your situation if you have a co-signer with good credit. A co-signer with a good to excellent credit score reduces some of the risks you pose for lenders. Your co-signer provides another way for them to recoup their monies if you default. You stand a better chance of approval with a reasonable interest rate.
Despite the advantages of saving thousands, be mindful of the risk posed to your co-signer. Make all your payments on time and in full, or their credit score will join yours in the red pile.
9. Can I pay off my car loan early?
Yes, you can repay a car loan early, but there are pros and cons.
On the pro side:
- You save on interest.
- You can free up funds for other expenses.
- You can avoid paying more for your car than it’s worth after its value depreciates.
While on the side of the cons:
- You won’t be able to accumulate points on your credit score as you make your monthly repayments on time and in full.
- You may not have the disposable income to tide you over after dropping a lump sum to pay off your car loan.
- You may face early repayment penalties, depending on your lender.
Avoid signing with lenders who penalize you for paying early.
A prepayment penalty is a fee lenders charge if borrowers choose to repay before the end of the originally agreed-upon deadline. Review all the terms of your car loan carefully. Not all lenders penalize borrowers for early repayment. Choose one that doesn’t for added flexibility in clearing off your debt.
Conclusion
The above questions do not cover all the ones you may have, but they are a start. Do further research, and don’t be afraid to ask questions. The more you know, the better you’ll be able to navigate the ins and outs of securing a car loan.
