What Are the Different Types of Car Loans?
When shopping for a car, there are several types of car loans you can choose from, including secured or unsecured, direct or indirect and simple-interest or precomputed-interest loans. Understanding how each type of auto loan works and their pros and cons can help you select the best financing for your needs.
Secured vs. Unsecured Car Loans
Auto loans can be secured, meaning the car itself serves as collateral, or unsecured, meaning there is no collateral. Secured auto loans are more common, but sometimes an unsecured loan may make more sense.
Secured Car Loans
Secured car loans use the vehicle you're financing as collateral for the loan. If you don't make your payments, the lender can repossess the car. Because secured loans are less risky for the lender, secured auto loans are generally easier to get and have lower interest rates than unsecured car loans.
| Pros | Cons |
|---|---|
| Typically easier to get than unsecured loans | Requires comprehensive/collision insurance on car |
| Often offer lower interest rate than unsecured loans | Down payment required to get best terms |
| Dealerships may offer special financing | Car can be repossessed if you don't pay |
| Interest may be tax deductible | Not always an option for used cars or private party sales |
Unsecured Car Loans
Unsecured auto loans are personal loans that you use to buy a car. Unsecured loans don't require collateral, so they're usually harder to get and have higher interest rates than secured auto loans.
Lenders can't repossess the car if you stop making payments on an unsecured loan. However, they can report missed payments or defaults to the major consumer credit bureaus (Experian, TransUnion and Equifax), damaging your credit score. They might also send your account to collections or sue you.
| Pros | Cons |
|---|---|
| No down payment required | Typically harder to get than secured loans |
| No car insurance requirements | May have higher interest rate than secured loans |
| Can be good option for used car or private party sales | Interest isn't tax deductible |
| Car can't be repossessed | Your credit score suffers if you don't pay the loan |
| Can use money for other purposes |
Learn more: Personal Loan vs. Auto Loan: How Should You Finance a Car?
Simple Interest vs. Precomputed Interest Car Loans
Most auto loans use simple interest, but some use precomputed interest. The way interest on your auto loan is calculated can impact your total cost, so it's important to know the difference.
Simple Interest Car Loans
Simple interest car loans calculate the interest you owe either daily or monthly based on your outstanding loan balance, not on the original loan amount. Most auto loans use simple interest, also known as loan amortization.
With a simple interest loan, making extra payments towards your loan principal reduces your loan balance, which reduces the amount of interest you owe. If you think you might pay your loan off early, or want the option to make extra principal payments each month, you'll want to get a simple interest loan.
| Pros | Cons |
|---|---|
| Early loan payoff or extra principal payments reduce the total interest you owe | Some lenders charge prepayment penalties for paying off your loan early |
Learn more: How to Pay Less Interest on a Car Loan
Precomputed Interest Car Loans
With a precomputed interest auto loan, the total interest you'll owe is calculated at the time you get the loan, with interest amounts allocated to each monthly payment. Interest payments are higher at the beginning of the loan term and gradually decrease, which looks a lot like a simple interest loan. But because interest is precomputed from the beginning based on your total loan amount, reducing your loan principal won't reduce the interest you owe.
Precomputed interest car loans aren't as common as simple interest loans and are most often offered to borrowers with poor credit. If you stick to your regular payment schedule, you'll pay the same total interest for a precomputed interest auto loan as you would for the same size simple interest auto loan with the same interest rate and terms. You just won't have the flexibility to save money by making extra payments.
| Pros | Cons |
|---|---|
| Paying off loan early may save money if lender refunds some interest | Paying off loan early won't save as much as with simple interest loan |
| If you stick to payment schedule, there's no difference in total interest compared to simple interest loan | Making extra principal payments won't reduce interest |
Learn more: Should You Make Extra Principal Payments on a Car Loan?
Direct vs. Indirect Car Loan Financing
You can finance a car by working directly with a bank, credit union or online lender, or indirectly, by having the auto dealership serve as a middleman to match you with a lender.
Direct Car Loan Financing
Direct auto loan financing means you apply for an auto loan directly with a bank, online lender or credit union. This lets you compare interest rates from various lenders, apply for the loan with the best terms and get preapproved. A preapproval letter locks in your interest rate for 30 to 60 days and shows the loan amount you're conditionally approved for, which can give you more leverage at the dealership.
| Pros | Cons |
|---|---|
| May save you money on interest | Not always the best interest rate |
| You have greater control over loan offers | Can be time-consuming |
| Gives you more negotiating power | Some lenders limit you to dealers in their network |
| Available for private party auto purchases |
Learn more: How to Get Preapproved for a Car Loan
Indirect Car Loan Financing
With indirect auto loan financing, you apply for an auto loan at the dealership. The dealer submits your credit application to multiple lenders. You'll then compare these dealer-arranged offers to choose the best loan.
In addition to dealer-arranged financing, auto dealers may also offer captive financing through the manufacturer's financing company. This is typically where you'll find special financing offers like 0% annual percentage rate (APR) auto loans.
| Pros | Cons |
|---|---|
| More convenient | No control over lender options |
| Promotional financing may offer lower rates than direct financing | Can cost more than direct financing if dealer takes a cut of the interest |
| May be better for borrowers with bad credit | Not an option for private party auto purchases |
Tip: You can boost your bargaining power by getting preapproval from a direct lender before visiting the dealership and asking if the dealer can beat that offer.
Special Types of Car Loans
There are some special types of car loans you may want to consider.
- Military car loans: Auto dealers sometimes offer military service members special financing, or discounts and rebates that can reduce the amount you need to borrow. Credit unions catering to service members can also be a source of low-interest auto loans.
- Buy here, pay here (BHPH) car loans: Catering to buyers with bad credit or no credit, BHPH auto loans are in-house loans from dealerships. They typically don't require a credit check but usually have higher interest rates than other types of auto loans and may require biweekly or weekly payments.
- Private party auto loans: You can get a private party car loan to buy a car from an individual by applying to banks, credit unions and online lenders. Private party auto loans typically cover only the cost of the car, not registration fees, sales taxes and other one-time expenses, so you'll need to cover those costs yourself.
- Auto lease buyout loans: You can use an auto lease buyout loan to purchase your leased car when the lease is up. Auto lease buyout loans are available from your lessor or from banks, credit unions and online lenders.
- Auto loan refinance: You might want to refinance your existing auto loan, replacing it with a new loan, if you can get a lower interest rate or want to lower your monthly payment.
- Cash-out auto loan refinance: You can tap the equity in your vehicle by replacing your current auto loan with a larger loan, ideally at a lower interest rate, and keeping the extra cash.
- Car title loans: If your car is paid off or close to it, you can use it as collateral to borrow cash quickly. But with APRs of 300% or more and repayment terms as short as 15 days, title loans are risky: The Consumer Financial Protection Bureau (CFPB) reports 20% of title loan borrowers ultimately have their cars repossessed.
How to Choose a Car Loan
Follow these steps to choose the best car loan for you.
- Know your credit score. Checking your credit report and credit score can give you an idea of the types of auto loans that may be a fit. Taking time to improve your credit score before applying for an auto loan may help you get a lower interest rate.
- Get preapproved. To shop for the best loan, get preapproved with several lenders. You can minimize any negative impact on your credit scores by keeping your rate shopping within a 14-day window.
- Compare loan offers. You can use Experian's car payment calculator to evaluate various loan offers, including loan amounts, interest rates and repayment terms.
- Know the total cost. In addition to interest rates, consider a loan's APR. This reflects the total cost of borrowing money, including interest and fees.
Tip: If you can't get the auto loan you want on your own, enlisting a cosigner who has good credit could help you qualify for a lower interest rate and more favorable terms.
Frequently Asked Questions
The Bottom Line
No matter what type of auto loan you've set your sights on, making a bigger down payment or opting for a shorter loan term could help you qualify for a lower interest rate. Shaping up your credit before you start shopping for loans is another smart move. Actions such as paying all your bills on time and paying down debt to reduce your credit utilization ratio can help improve your credit score, which could make you eligible for a lower-interest auto loan.
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About the author
Karen Axelton
Karen Axelton specializes in writing about business and entrepreneurship. She has created content for companies including American Express, Bank of America, MetLife, Amazon, Cox Media, Intel, Intuit, Microsoft and Xerox.
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