Your guide to car loans

Buying a car is typically a significant investment, big enough that it requires most people to take out a car loan. Though not quite as varied as the cars they help finance, different types of car loans can suit different consumer needs. Understanding those loans can help you find the financing option that’s right for you. Most loans available to purchase a car can be broadly categorized as follows:

Secured loans vs. unsecured loans                                    

When researching different types of car loans, you’ll probably see some wording regarding the loan being either secured or unsecured.

Secured loans

Virtually all car loans are secured, which means they’re backed by a lien on the underlying asset — the car itself. A lien is a legal claim that allows your lender to repossess the car if you fall behind on your payments. Once the loan is fully paid off, the lien is released.

Unsecured loans

Unsecured loans involve no security, or collateral, for the lender. While mainstream consumer lenders may offer unsecured loans that you can use to buy a car (or anything else), these loans tend to have a higher interest rate. Another alternative to these unsecured loans to buy a car is to get a loan from friends or family. However, in the event of non-payment, the lender may take legal action to obtain money owed, or even to get the vehicle.

Simple interest vs. pre-computed interest

Speaking of interest rates, most auto loans accrue interest on a simple interest basis, not on what’s known as a “pre-computed” basis.

Simple interest car loans

Simple interest car loans accrue interest on the outstanding balance on a daily basis. Making larger or additional payments can help accelerate the reduction of outstanding principal, and the eventual payoff of the loan, and potentially lower the total interest paid.

Pre-computed interest car loans

For car loans with pre-computed interest, interest accrual and payment amounts are fixed, and making larger or additional payments — or paying early — won’t reduce the payoff amount or have any bearing on the total interest owed. Pre-computed car loans are rare in the market.

Direct financing vs. indirect financing

Another way to distinguish car loans is based on the loan originator. This can be broadly broken into direct and indirect financing.

Direct financing

Direct financing comes directly from the lender, such as a bank, credit union or other financial institution. Buyers can potentially secure the loan or get prequalified before they start car shopping to help form a clearer picture of what they can qualify for.

Indirect financing

Indirect financing typically refers to a dealership arranging for financing on your behalf. The dealership serves as the original creditor, working with the buyer to establish an acceptable interest rate, repayment period and other terms. The dealership may then sell the contract of sale and credit to a financing institution such as a bank.

Other types of car loans

Besides the types of car loans mentioned above, there are other specialty loans that may be helpful to know about.

Title loan

A title loan utilizes your current vehicle’s equity as collateral for the loan. Vehicle equity would be the difference between the value of the car and any money that you owe on it. As is the case with other secured loans, the title lender places a lien on the car, allowing the car to be repossessed and sold to cover the amount owed if the terms of the loan aren’t met. Title loans typically carry very high interest rates and short repayment terms.

Another consideration: Lease buyout

At the end of a leasing contract you may have the option to buy the vehicle for a predetermined price, usually called residual value. If you require financing to be able to do so, you may be able to take out a loan for this purpose. If you decide that you want to buy your leased car before the end of the lease term, check your lease contract to understand if there are any fees or charges to do so, and see if there is any impact to the pre-negotiated residual value.

In summary

When it comes to car loans, it’s generally helpful to consider your options carefully before committing to one type of loan over another, or maybe you decide that a lease is a better option than a car loan. Understanding your alternatives can help you decide the type of loan that might work best for you.