Buying a car is usually a significant investment, large enough that most people need to take out a car loan. While not as varied as the cars they help finance, different types of car loans can meet different consumer needs. Understanding these loans will help you find the financing option that’s right for you. Most of the loans available to buy a car can be roughly classified as follows:
Secured Loans vs. Unsecured Loans
When researching different types of car loans, you will probably come across some wording regarding whether or not the loan is secured.
Virtually all car loans are backed, meaning they are backed by a lien on the underlying asset – the car itself. A lien is a legal claim that allows your lender to take the car back if you are behind on your payments. Once the loan is paid off in full, the lien is released.
Unsecured loans do not hold any security or collateral for the lender. While regular consumer lenders may offer unsecured loans that you can use to buy a car (or something else), these loans typically have a higher interest rate. Another alternative to these unsecured loans to buy a car is to get a loan from friends or family. In the event of non-payment, however, the lender can take legal action to obtain the money owed, or even get the vehicle.
Simple interest versus pre-calculated interest
Speaking of interest rates, most auto loans generate interest on a simple interest basis, not on what’s known as a “pre-calculated” basis.
Simple interest car loans
Simple interest car loans yield daily interest on the outstanding balance. Making larger or additional payments can help accelerate the reduction of principal and final loan disbursement, and potentially reduce the total interest paid.
Pre-calculated car loans with interest
For auto loans with pre-calculated interest, the interest accrual and payment amounts are fixed, and making larger or additional payments – or paying early – will not reduce the payout amount and will not affect the total interest owed. Pre-calculated car loans are rare in the market.
Direct Financing vs Indirect Financing
Another way to differentiate car loans is based on the lender. This can be roughly divided into direct and indirect financing.
Direct financing comes directly from the lender, such as a Bank, credit union or other financial institution. Buyers may be able to secure the loan or be prequalified before starting car shopping to get a clearer picture of what they might qualify for.
Indirect financing usually refers to a dealership that arranges financing on your behalf. The dealer acts as the original creditor and works with the buyer to determine an acceptable interest rate, repayment period, and other terms. The dealer can then sell the sales and credit contract to a financing institution such as a bank.
Other types of car loans
In addition to the types of car loans mentioned above, there are other special loans that may be useful to know.
A title loan uses the equity of your current vehicle as collateral for the loan. Vehicle power would be the difference between the value of the car and the money you owe on it. As is the case with other secured loans, the 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 are not met. Title loans typically have very high interest rates and short repayment terms.
Another consideration: Lease buyout
At the end of a lease, you may have the option to purchase the vehicle for a predetermined price, usually called residual value. If you need financing for this, you may be able to take out a loan for this. If you decide that you want to buy your lease car before the end of the lease period, check your lease contract to see if there are any costs or costs involved and see if there are any consequences for the pre-negotiated residual value.
When it comes to car loans, it is generally helpful to carefully consider your options before committing to one type of loan over another, or you may decide that a lease is a better option than a car loan. Understanding your alternatives will help you determine which type of loan is best for you.