Basics of an Auto Loan

Consumers have used auto loans to purchase vehicles since the early 1900’s and they remain a popular way to finance a vehicle, instead of emptying your savings account. A big reason for their popularity is due to auto loans being collateralized loans, and therefore are easier to get approved for when buying a vehicle, compared to other uncollateralized lending options. Secured loans, or collateralized loans, are loans offered by a financial institution in exchange for something tangible from the borrower if the borrower fails to repay the loan. Example: Bank ABC will lend you $20,000 to buy a vehicle, in exchange for a lien on the vehicle as collateral. If you do not pay the auto loan, the bank reserves the right to repossess the vehicle. In comparison, unsecured loans are loans offered by a financial institution without the exchange of something tangible from the borrower. Secured loans are typically easier to get approved for and have more favorable terms than unsecured lending options.

Financing: Dealer vs Bank/Credit Union vs Broker

There are three common ways to shop for an auto loan when buying a vehicle:

Dealer financing – Using a new or used car dealership’s finance office. They typically have relationships with several lenders, or use software that will shop lenders based on your credit score and requested loan amount. Dealers could charge you a higher rate than quoted, and take the difference as profit for writing the loan for you.

A bank or credit union – Most banks and credit unions will offer an auto loan. Credit unions could have slightly better terms (interest rate and length of low, resulting in a lower monthly payment potentially), but could also have stricter lending requirements on the vehicle (might not finance an older vehicle, or might have loan amount limits).

Using a broker – For example: AAA. Very similar to dealer financing, a broker will use a list of lenders and give you options based on your credit score and requested loan amount. Unlike dealers, brokers are not usually able to charge a higher rate than quoted, and instead are compensated directly from the lender that writes the loan for you.

What’s important? Rate, Length, or Payment?

You’ll have to decide what’s most important to you when choosing the terms of an auto loan: the interest rate of the loan, the length of the loan, or the monthly payment of the loan. If you want the lowest interest rate, then the length of the loan will be shorter and the monthly payment will be higher. If you want the longest length of the loan, then the interest rate will be higher and the monthly payment will be smaller. 

Interest Rates – Rates for a new vehicle are typically between 0% to 8%, and for a used vehicle are typically 2% to 15%. You’ll be able to select the interest rate based on your credit score, age of vehicle, length of loan, and loan amount.

Length of Loan – Loan terms historically have been between 3 to 5 years (36 to 60 months), but in recent years we’ve seen loans stretch to 8 years (96 months). You’ll be able to select the length of the loan based on your credit score, age of vehicle, interest rate, and loan amount.

Loan to Value – Most lenders will lend up to 120% of the value of the vehicle, and could ask for a 0% to 20% down payment depending on your credit score and age of vehicle. This includes new and used vehicles. This also includes potentially financing upfront fees when buying a vehicle through a dealer.

Our Take.. Good or Bad?

For most people, an auto loan is a tool to purchase a reliable vehicle that will last longer than a vehicle they could buy without an auto loan. It’s important to weigh your options when buying a vehicle though. Do you need a car or truck? Do you need two doors or four doors? Do you want a base model or a higher trim model? If you’re single looking for something to and from work, your needs will differ from a married individual with two kids, and your budget will differ respectfully.

It’s important to also determine how efficient you want your budget to be. If you buy new, you’ll typically have 2-5 years with very little maintenance required, other than oil changes every  3-5 months and tires every 12-18 months. New vehicles will have more generational improvements as well; higher safety ratings, better gas mileage, more tech features, etc. If you buy used, you should understand the vehicle could need maintenance within the next couple years. You should also understand an older vehicle might not have the features you’re looking for. It’s up to you to determine if heated seats and self-driving is worth it.

All in all, we recommend an auto loan to purchase a vehicle. It’s almost always a good idea to keep your cash in your investments, emergency fund, or savings account (in that order). Especially if you’re able to get an interest rate for 0%-4% on a vehicle that will last you 2-5 years without any major maintenance, and ultimately will last you 10+ years if you take care of it regularly.

Reminder – Even though we are recommending using an auto loan to purchase a vehicle, it’s important to remember to remain focused on your financial goals. We recommend to limit your auto loan to 5 years or less (60 months or less), don’t finance over 90% of the vehicle’s value at the time of signing, and keep the payment under 15% of your net income (including insurance and fuel). For example: If your net income is $5,000 per month, you should spend no more than $700 a month on transportation (auto loan payment, insurance, and fuel).