Types of Car Loans: Which is Right for You?

Are you in the market for a new ride? Or maybe you want to refinance an existing loan. In any case, before you shop around with lenders, you should become acquainted with the many types of vehicle loans accessible.

All auto loans allow you to borrow money and pay in installments (including interest and principal) over a set period of time. However, make sure you understand the distinctions between the various forms of vehicle loans so you can select the best one for you.

Auto loans

You can use a car loan to secure a new or used car. Keep in mind that used car financing has strict lending guidelines. To assess which cars qualify for credit, lenders establish age and mileage limitations.

These loans are accessible from traditional banks, credit unions, and online lenders. Or you can use merchant financing to make the process smoother - but expect higher borrowing costs for added convenience if you choose this option.

The amount you qualify for is determined by the type of loan you want (new or used auto loan) and your personal financial situation. Each lender has its own guidelines, and some offer loans into six figures.

New and used car loans usually come with repayment terms of between three and five years, but some lenders offer loan terms of up to 84 or even 96 months.

Depending on the financing arrangements, you may also be required to make an advance payment. Financial experts recommend taking at least 20 percent down, but it's best to pay what you can comfortably afford.

Loan amount, interest rate and repayment term determine your monthly payment - try Bankrate's auto loan calculator to get an estimate.

Private party car loans

A private party car loan is a loan taken out specifically for the purchase of a vehicle owned by a private party. This form of loan is available through banks, credit unions, and online lenders. Prices are slightly higher than if you were buying a car from a dealership.

Lenders place limits on the types of vehicles you can purchase. Cars generally must be 10 years or less old and have less than 100,000 miles.

Rental purchase loans

A lease-to-purchase loan allows you to keep your rental car after the contract expires. You can use it to finance the purchase of a car, as specified in the lease agreement.

Your monthly payment may be higher than your rent payments because the latter only covers depreciation. After the final payment, the car is yours.

Auto refinance loans

An auto refinance loan allows you to convert your existing loan into a new one. This is often used to extend the term of your loan for a reasonable rate or to lower your monthly payment. Or you can refinance to shorten the loan term and pay off the loan faster.

Refinancing a car loan can be a smart financial move for several reasons. If market interest rates have fallen since you took out your existing loan, it's worth asking if a better deal is available. You may also qualify for a better deal if your credit score is higher than when you initially applied or if you used merchant financing and didn't get the best rate.

Cash-out Auto refinance loans

A cash refinance loan is similar to a traditional refinance but allows you to convert the difference between the equity or value in your car and what you owe into cash. You will replace your current loan with a new one that includes the principal you obtained.

The amount you can withdraw is usually limited to the balance in your car. However, this loan can be useful if you need cash quickly, and more attractive terms and affordable monthly payments are possible.

Keep in mind that more principal usually means that you will pay more interest over the life of the loan. Also, not all lenders offer auto refinance loans so you will need to do some legal work to find a lender that can help. Finally, remember that increasing the amount you owe puts you at greater risk of foreclosure.

Other forms of auto loans

The above types of auto loans also differ based on how the interest is calculated, where the loan is obtained, and whether the loan is collateralised.

Simple interest loans versus pre-calculated interest auto loans

Car loans can have two types of interest: simple or pre-calculated interest loans. Simple interest loans are more common. They compute the monthly interest payment depending on the current principle balance. As your principal balance shrinks, so does the amount of interest you owe on each payment. So, if you pay more than the minimum each month, you can save an interest-bearing bundle and pay off the loan sooner.

You will usually find pre-calculated interest loans from lenders who work with bad credit buyers. In precalculated interest loans, the loan balance, origination fee, and interest are calculated at the outset and spread over the entire loan term according to a formula called Rule 78.

If you make minimum payments each month over the life of the loan, there is little difference between a simple interest loan and a precalculated interest loan. However, if you plan to pay off the loan early or make a larger payment, a pre-calculated interest loan will not save you money because the interest for the entire loan term is already included in the monthly payment amount.

Direct car financing vs. indirect car financing

Direct financing is when you get car financing through an outside dealership lender. Getting approved or pre-approved for an auto loan with the lender before going to the dealership can give you more bargaining power during negotiations.

Along with the interest rate and loan term, you will know how much you are entitled to borrow. With this information, you can anticipate the car purchase by knowing the size of your budget.

When you're ready to close the deal, the merchant verifies the information and completes the transaction. Or you can use the offer you received to negotiate a better financing deal with the merchant.

With indirect financing, the merchant provides his financing through his lending partners. You work with the merchant to fill out your auto loan application, and the merchant sends the application to the lender or lenders. While indirect financing may be appropriate, the interest rate can be set by the trader to ensure profitability. There is no way to know if you are getting the best deal available because the agent handles the financing process from start to finish.

Secured vs. Unsecured Car Loans

Most auto loans are secured.

A secured car loan requires collateral to get approved - usually the car itself. If you apply for a secured loan, you may have better odds of approval and a more attractive interest rate, since this type of loan carries less risk to the lender. If you default, the lender can repossess the car.

Unsecured car loans are personal loans used to purchase a new or used car. They often come with strict eligibility guidelines and high interest rates because collateral is not required. To qualify, you'll typically need a strong credit score and payment history, as well as a stable and verifiable source of income.

Bottom Line

There are similarities between auto loans, but there are important differences to remember when deciding which option is best. The option best suited to your financial needs and budget will depend on your goal for the loan—whether you want to replace your existing loan, buy a new car from a dealership, or something else.

Before deciding which type of car loan is best, do your homework to understand what each of them offers. Also, you can shop around to find the best lenders and get pre-approved to ensure you get a competitive financing offer.