Choosing the Right Car Loan Option for You
If you're looking to secure your ideal, cost-effective car loan, here's what you need to know.
Navigating the world of auto financing can be daunting. As average car loan interest rates continue to rise, finding an auto loan with a monthly payment that fits within your budget is becoming more and more challenging.
If you're considering financing a car, it's important to understand how to choose the right car loan to stay on top of your finances. When starting the loan process, buyers need to properly assess their financial and credit situations in order to land the best car loan option.
Financial Considerations for Securing Car Loans
As you start exploring your car loan options, be sure to identify and carefully consider these factors that impact your financial situation and the potential terms a lender can offer you.
- Credit score: Your FICO credit score lets lenders know how reliable you'll be at paying back your loan. If you have a score of more than 700, that's typically considered good by most lenders. In 2022, the national average credit score was 714.
- Desired term length: Depending on your lender, your principal, and the car itself, your loan term can last anywhere from two to seven years or even longer. However, the longer your loan term is, the more you could potentially pay in interest — thereby increasing the lifetime costs of your loan.
- Lender options: From banks to dealers to third parties to friends and family, each potential lender will have different terms specific to their financial needs and their assessment of risk. Research the right lender option for you and see which one best fits your ability to pay off your loan on time.
Understanding Your Car Loan Options
Understanding the typical terms used with car loans will come in handy when deciding which auto loan is right for your financial situation. We've grouped these into three sections that follow choices you'll have to make depending on either the type of vehicle you're financing or your personal credit situation.
The first thing you'll decide is which type of lender you want to finance through. Auto loans are traditionally financed through a financial institution, but there are also dealerships that will finance a vehicle in-house.
- Direct financing: The most traditional form of financing, direct financing refers to the process by which a buyer takes a loan directly from a financial institution, whether a bank, credit union, or other kind of lender. Though it requires more work on the borrower's part, this approach allows for more customization in loan structure and potentially friendlier rates and terms.
- Indirect financing: Also sometimes referred to as in-house financing or "buy here, pay here" loans, this form of financing is provided by the dealership themselves rather than a traditional lender. Financing through dealerships could be more convenient and easier to qualify for, but it often comes with a shorter list of options that provide less flexibility in terms of customization. Also note that while "buy here, pay here" dealerships can be convenient, they usually charge higher interest rates and have some notable caveats.
In direct financing situations, you may have the choice of getting a secured or unsecured loan. Depending on the loan length and terms you're looking for, one of these common options may be more appealing than the other.
- Secured loans: These are car loans that use your vehicle as the physical collateral for the loan itself. Your lender might request the deed to your car, thereby allowing them to reclaim it if you fail to make your loan payments. Secured loans tend to be longer-term agreements with lower interest rates and terms, especially for shoppers with poor credit.
- Unsecured loans: These car loans are the exact opposite of secured loans because they have no physical collateral. Therefore, lenders take on increased risk, which they typically offset through higher interest rates. This could be beneficial for buyers who can pay off their loans quickly. This may also be the only loan type available for higher mileage or older cars. These tend to be shorter loan terms as well.
Once you've chosen between a secured or unsecured loan, you will want to get familiar with two types of interest.
- Simple interest: The most common interest rate on a car loan is simple interest, which is based on your principal. If you know you can pay your bill on time each month, this could be the ideal choice for your car loan.
- Precomputed interest: A less common format for loans is precomputed interest. In this instance, lenders calculate the overall cost of interest at the point of purchase and incorporate that into payments right from the start. Pre-computed interest is typically reserved for buyers with poor credit where the lender wants to establish foundational costs and terms upfront to protect themselves from lending risk.