Understanding the Different Types of Auto Loans

Jim TrummDec 1, 2017

More than two-thirds of all new and used car purchases are financed by borrowed money. That figure rises to about 85% if only new car purchases are considered. Of the vehicle purchasers who borrow money to buy a car, about half obtain loans at the car dealership, while the other half borrow from banks, credit unions, and internet lenders. 

Since chances are good that you’ll be borrowing money in order to get the keys to a new ride, it pays to understand the different types of loans that are available.

Secured vs. Unsecured Auto Loans: What's the Difference?

The most common types of auto loans are secured by the vehicle itself. This means that the bank or finance company has a security interest in the vehicle written into the vehicle title and can seize the vehicle if the borrower defaults on the loan. In this respect, it’s like a mortgage. 

There are a few finance companies, however, that offer unsecured loans that can be used to purchase a car or truck. With these loans, the lender has no security interest in the vehicle. In this respect, such loans are more like using a credit card to make a purchase. Unsecured auto loans are generally only offered to people with high credit scores and substantial income and assets. Because they expose the lender to more risk, they often come at a higher interest rate than secured loans do.

What's the Difference Between Pre-Computed Interest and Simple Interest Loans?

The interest on a car loan is the price you pay for using someone else’s money to buy your car or truck. There are two ways this interest is commonly computed and structured. Simple interest loans require a monthly payment that includes payment of the interest on the loan’s outstanding balance. So, for example, if you borrowed $15,000 to buy your vehicle but have now paid down the amount owed to $6000, you will pay interest only on that outstanding $6,000 balance.

Pre-computed interest, however, is based on a calculation of what the sum total of the interest will be over the life of the loan. That figure is divided by the number of months of the loan term. Each month’s payment includes the same monthly interest payment. In that case, you pay the same amount of interest each month regardless of the balance on the loan.

If you pay your auto loans off in the amount of time specified by the term but not before, there is usually no or very little difference between the total interest paid under pre-computed and simple interest loans. However, if you pay more than the minimum due on the note each month and pay your note off early, you will reap some financial advantage from a simple interest loan, since excess payments are applied against the outstanding principal. That means that interest portion of subsequent payments will be lower.

Dealer Purchase Car Loans

While car loans are available from banks, credit unions, and internet lenders, car dealers are another source of vehicle financing. In this scenario, the dealership salesman’s office becomes one-stop shopping for both the vehicle and the financing. Car dealerships often have financial arrangements with several lending companies and will be glad to help you get a loan from one of them. This sounds easy—and it is—but that ease may come at a price. Consumers on their own can compare the interest rates and terms of many lenders. But consumers who invite the dealership to make the financing arrangements are looking at a single take-it-or-leave it offer. In other words, you are surrendering your ability to shop around for a better loan.

Auto manufacturers and dealers frequently advertise terrific low- or no-interest car loans to customers. These can be good deals, but they’re generally available only to people with perfect credit histories. For people with less than stellar credit records, car dealerships can push through loans that the consumer might not be able to get on his own. But as noted above, surrendering the ability to shop for your own car loan comes at a cost.

Lease Buyout Car Loans

Another species of auto loans is the lease buyout loan, where a financial institution lends you the money to buy the vehicle you’ve been leasing at the end of the lease term. Buying the vehicle you’ve leased can be a good option in some circumstances. By the end of a lease term, you are more familiar than anyone with your vehicle’s maintenance and accident history. And you’ve had years of test-driving, so you know what you like and don’t like about the vehicle. Further, buying out your own lease helps avoid penalty fees for damage, excessive wear and tear, or going over your mileage limit.

You could, of course, just finance the lease buyout through the same company that financed your lease. But it also might pay to shop around for a better rate.

Private Party Purchase Car Loans

From a financing point of view, getting a loan to buy a used car from a dealership is very similar to getting a loan to buy a used car from an individual. However, there may be additional steps involved in the transaction.

The critical question is whether the seller still has an outstanding car loan. In that case, the seller’s finance company has a legal interest in the vehicle, so your own finance company isn’t going to let the deal go through unless and until the note on the owner’s car is discharged. This can get tricky if the seller intends to use the proceeds of the sale to pay off his or her outstanding loan balance. In that case, your finance company will likely insist that an amount equivalent to the loan balance be escrowed and then paid to the original finance company once the deal goes through.

Regardless of what kind of auto loan you want, shopping around is critical. Don’t think of a car loan just as a kind of paperwork to be gone through before you buy a vehicle. The loan is a purchase in itself, one that will likely cost hundreds or thousands of dollars. Comparing rates from our top auto loan companies and other lenders may save you considerable money over the life of the loan.