What Is an Auto Loan?

How Auto Loans Work

When buying a car, you can either pay for the vehicle with cash upfront or use an auto loan. When you use an auto loan to buy a car, the vehicle's seller is paid all at once when the loan is issued, and you then make monthly payments to the lender for a set period of time.

Here are some important auto loan terms you should know:

• Interest rate: This is how much you'll pay to the lender in interest on top of your loan principal payments. You'll pay more toward interest at first, but your loan payments will stay the same throughout the life of a fixed-rate loan.
• Down payment: This is an amount you may offer to the seller in cash, effectively reducing the amount you need to finance. The larger the down payment, the better terms you can obtain.
• Repayment period (or loan term): Depending on the lender and the loan amount, you may be able to pay back your loan over 36 to 96 months, or three to eight years. Loans with shorter repayment terms tend to offer more favorable terms, but higher monthly payments.
• APR: Also known as the annual percentage rate, this is the total cost of borrowing that you pay each year expressed as a percentage. It includes the loan's interest rate and any fees the lender may charge. When comparing similar loans, be sure to look at the APR in addition to the interest rate as lender fees may vary.
• Collateral: Auto loans are typically secured loans, which means they use the vehicle as collateral. As a result, auto loans tend to have lower interest rates than unsecured loans, such as personal loans. That said, the lender technically owns the car and holds the title until you pay off the loan. If you fail to keep up with payments, the lender can repossess the vehicle.
• Prepayment penalty: Some lenders may charge a prepayment penalty if you pay off the loan too soon. Watch out for this in the contract before you sign it.

What Credit Score Is Used for Auto Loans?

When you apply for an auto loan, the lender will run a hard inquiry on your credit reports to determine your eligibility.

Auto lenders typically use a specialized version of the FICO^® Score^☉ called the FICO Auto Score. This scoring model is very similar to the base FICO^® Score, but it puts more weight on how you've managed your auto loan payments in the past.

You can get access to your FICO Auto Score by using credit services such as Experian CreditWorks℠ Premium. Even without your FICO Auto Score at hand, however, your base FICO^® Score should give you a good enough idea of what to expect. You can get access to your FICO^® Score for free through Experian.

Auto loans are available for consumers across the credit spectrum, but the higher your credit score, the better your chances of securing a loan with a lower interest rate. To qualify for competitive rates, it helps to have a credit score of 670 or higher. If you have a score of 720 or above, you can typically qualify for the best rates lenders have to offer.

What Is a Good Rate for an Auto Loan?

The auto loan rate you qualify for will be based on a variety of factors, including your credit score, down payment, repayment term and more.

To give you an idea of how auto loan rates work out based on credit, here's what Experian found for the first quarter of 2022:

Source: Experian

However, we can expect auto loan rates to increase in the near future as the Federal Reserve continues to hike interest rates. So, if you've been considering buying a car, sooner may be better than later if you're hoping to score a lower interest rate.

How to Get an Auto Loan

There are two different ways you can get an auto loan: direct and indirect financing. Here's how the process works for each option.

Direct Financing

With this approach, you work directly with the lender, which may be a bank, credit union or online lender. Here are the steps you'll take:

1. Determine how much car you can afford based on the total monthly costs, including the loan payment, insurance, gas, maintenance and repairs.
2. Check your credit score to determine what to expect.
3. Shop around and apply or get prequalified with multiple lenders to determine which lender offers the best terms.
4. Get preapproved with the lender of your choice.
5. Take the preapproval to the dealer and pick out your vehicle.
6. Complete the auto loan process by finalizing the terms with the lender and signing the loan agreement.

Indirect Financing

Also called dealer-arranged financing, this option involves letting the dealer take care of the process. Indirect financing is more convenient, but in some cases, the dealer may quote you a higher rate than what the lender quoted and take the difference as compensation.

Here are the steps for indirect financing:

1. Determine how much car you can afford based on the total monthly costs, including the loan payment, insurance, gas, maintenance and repairs.
2. Check your credit score to determine what to expect.
3. Visit the dealership and pick out your vehicle.
4. Fill out a credit application for the dealer to submit to multiple lenders.
5. Ask the dealer to provide all of the offers instead of just one to ensure you're getting the best deal. You may also consider applying with some lenders on your own for further comparison.
6. Pick the lender you want to work with and sign the agreement.

Make Sure Your Credit Is Ready for a Car Loan

While it may be tempting to apply for an auto loan sooner rather than later to take advantage of lower rates, working on your credit score may ultimately give you more savings. If your credit needs some work, take steps to improve your credit history before applying.

This process can take several months, but there are some things you can do that may provide results more quickly. While you're at it, monitor your credit score regularly to track your progress and determine which areas you need to address.