There are two main types of car loans:
- A loan obtained to purchase a car. The car itself if typically used as collateral for the loan. This type of loan can often be arranged through the car dealership, who works with a third party lender. It is also common for banks to offer car loans. This type of car loan is paid of gradually with monthly installments.
- A loan where the car is collateral for the loan, but where the borrowed money was not used to buy the car. It is known as car title loan, auto title loan, pink slip loan (USA) or logbook loan (UK). This type of loan tend to be small and short-term, and have a considerably higher interest rate than the type of loan described above, as it targets borrower that cannot obtain better forms of credit. The term of the loan will typically be 30 days or less.
In this article we will focus on the first type of loan; the loan obtained to purchase the vehicle used as collateral for the loan. Unlike a pawnshop that keeps your pawned possession until the loan is paid back, the car loan lender will let you use the car while you gradually pay back the principal, interest and fees. After all, the whole purpose with this type of car loan is to facilitate the sale of cars. In this regard, the car loan is quite similar to a house mortgage loan – you are allowed to live in your house while you pay off the house mortgage loan and you are allowed to use your car while you pay off your car loan. In both cases, you become the owner of the property right away and assumes responsibility for it, but the property can be repossessed by the lender if you default on your loan.
Car loans are available both for used cars and new cars. Licensed car dealers normally work together with a retail bank or a specialized car financing company, and you can arrange a car loan through them. Some large car manufacturers have their own financing firms.
It is always advisable to research all your financing options before you make a decision. Your bank may for instance be able to offer a better car loan than the one available through the car dealership.
- Since the borrower uses the car as collateral for the car loan, lenders are often willing to have rather low requirements regarding the borrowers financial situation. You may for instance qualify for a car loan even if you have a poor credit rating.
- If you are not purchasing your car through a licensed car dealer, it can be more difficult to obtain a car loan.
- Since the lender wants to be able to repossess the vehicle if you default on your car loan, there will typically be provisions in the loan contract regarding car insurance. Just having the basic (legally mandated) insurance will rarely be enough to satisfy the lender.
Alternatives to the classic car loan
- Car leasing
- Hire purchase
- Personal contract purchase