What is an Auto Loan?

An auto loan allows someone to borrow money to purchase a car or truck. Auto loans are usually simple-interest loans that are to be paid back over a period of typically three or five years.

A car is often the second-largest purchase someone will make aside from their home. Auto loans help make vehicles that often cost tens of thousands of dollars more affordable by breaking up the high cost into monthly payments that work with different borrower's budgets.

How Do Auto Loans Work?

Auto loans are simple-interest loans, where the lender expects to be repaid by the borrower in monthly installments for the amount they lent (the principal), plus interest (the cost of borrowing from the lender, shown as a percentage of the principal balance).

For example, let's say you want to buy a $20,000 car. After putting $2,000 down, you decide you want to take out an auto loan to finance the remaining $18,000 (the principal). After shopping around and submitting your financial information to lenders, several lenders have offered you an auto loan for this amount with an interest rate -- typically referred to as an annual percentage rate (APR) -- of 5%.

By plugging this into a car loan calculator, you can find out what your payments might be over a variety of terms to see what's most affordable on a monthly basis. If you chose a 60-month (five year) auto loan for $18,000 financed at 5%, for example, your payments would be $340 per month and you'd pay $2,381 in interest charges over the course of the loan.

If you chose a 36-month (three year) auto loan on these terms, your payments would be a costlier $539 per month but you'd only pay $1,421 in interest charges.

How Long is the Repayment Period for an Auto Loan?

Depending on your credit rating, annual income, and the size of the loan, you may be offered auto loans with a wide range of time-related repayment terms. Typically, a borrower is expected to pay back the lender in monthly installments over the course of one to five years (whatever the borrower and lender agree upon).

That said, with many buyers purchasing more expensive vehicles these days, many lenders now offer auto loans with repayment terms of up to 80 months (7 years). A longer repayment term may make your monthly payments smaller than they would be under a shorter term auto loan, but you would also have to pay more in interest charges over the life of the loan as you would have to make more payments (with interest) overall.

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Financing a Car Through a Bank Vs a Dealership

Many car buyers apply for an auto loan through a lender or bank, which will assess the your credit score, annual income, job history and other factors that determine how likely you are to repay. Generally, the higher your income and credit score is, the larger the loan amount and the lower the interest rate you can expect to be offered by a lender, respectively.

Alternatively, you may also apply through a car dealer after you've selected a car to buy. Typically, dealer auto loans come with higher interest rates than pre-purchase lender loans. However, buyers with exceptional credit (credit scores above 750) can sometimes get 0% financing from a dealer for a certain period of time.

Can a Personal Loan Be Used to Buy a Car?

Many lenders will only approve auto loans for cars that are a certain age (typically 5 years or less). Because an auto loan is a 'secured' type of loan, the car that is being financed is used as collateral (i.e. if you fail to repay your auto loan, your car may be seized by the lender, who then may sell the car to get some of its money back). And because cars depreciate and lose value over time, lenders don't like to offer auto loans on older cars as they may not be able to recoup as much in the event that you can't repay.

What to do? If the car you want to buy is older than what the lender requires for an auto loan, you may consider taking out a personal loan to finance the purchase. Personal loans typically come with higher interest rates and may require higher credit scores, but because they are 'unsecured,' your car will not be used as collateral by the lender and can't be taken outright if you fail to repay the loan.

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