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How Do Car Loans Work?

How do Car Loans Work?

Car loans are a type of personal loan that is used to purchase a new, or used car. A car loan is unsecured, while some lenders choose to take security over the vehicle. Car loans are arranged between 3-10 working days. In the United Kingdom, car loan lenders provide car loans faster than many other loan types, such as secured loans and mortgages. Each lender has a process that the car loan applicant should follow which involves a credit check and car loan affordability assessment.

The car loan process involves completing the steps required for the application process, followed by receiving the car loan. Every money lender including banks have different sub-processes for car loans. They usually involved credit checks, employment, ID checks and affordability checks. Car loan affordability assessment involves checking that your income is sufficient to maintain the monthly repayments, and checking that your income is what you stated in your application.

Car loans are becoming a very popular option for those looking to purchase a new vehicle. This is because they allow you to separate your finances from the dealer, leaving you free to compare products from the likes of Santander and the AA in search of the best deal.

Reducing your rate can lead to big savings on your monthly payments, as we break down below. The best car loan rates available can vary from person to person depending on the size of the loan, the borrower’s credit history and income.

What determines a car loan monthly payment?

When looking to take out a loan, your monthly payments are all important, here we break down the key factors that can impact how much you pay each month.

The car loan amount

The amount that you will be borrowing is the biggest factor that impacts your monthly payments. When borrowing a greater amount over a fixed period of time, you must pay more each month to repay the loan on time.

The car loan Annual Percentage Rate (APR)

APR is a calculation that allows you to understand the cost of borrowing over a year. A lower APR means lower car loan interest rate and fees, which will reduce your monthly payment. For example, when borrowing £1,000 at an APR of 5%, you will pay £50 in interest and fees. This would jump to £100 if the Annual Percentage Rate rose to 10%.

The car loan term

When talking about loans, the term is the amount of time that the funds will be borrowed over. When borrowing over a shorter term, your monthly payments will increase, but the total cost of credit (TCC) will reduce. The inverse is also true, a longer term means lower monthly repayments, but a higher total cost.

Each of these factors is key in deciding the cost of your loan, so it’s important that you find the right balance between each to ensure that your loan is affordable. 

Example car loan monthly payment calculation

While it’s important to understand the factors that impact your monthly payments, understanding how much you’ll pay each month is key.

Here we break down an example of how a car loan payment works. If you’d like to know how much you could pay, try our car loan payment calculator.

Example:

Simon is looking to buy a new car for £12,000 and has £2,000 in savings, meaning he needs a loan for £10,000. When comparing car loans online, the best car loan rate available to him was 6.5% per annum and the lender offered a term of between 2-5 years. Depending on the loan term selected, his monthly payments would be the following:

  • 2 years – £444.62
  • 3 years – £305.64
  • 4 years – £236.29
  • 5 years – £194.79

How to choose a product when applying for a car loan

When it comes to car loans, choosing the right deal usually comes down to your ability to qualify for the product, and cost.

As the service offered by each lender is similar, look for the loan with the lowest APR that you’re likely to qualify for. The easiest way to do this is using an online car loan comparison service, ideally one with a built-in eligibility check.

What will I need to provide when I apply for a car loan?

When you apply for a car loan, the lender will usually require the following information:

  • Your personal information – The lender will require your personal information to assess your application and conduct a credit search. 
  • Your financial details – In most cases, lenders can verify your income through Open Banking, however, where this isn’t possible, you will be asked for proof of income and details of your outgoings. This will allow the lender to ensure that your proposed loan is affordable.

What are the limits for car loan interest rates?

The minimum and maximums vary depending on the amount you wish to borrow. Car loan interest rates can be broken down by tier, with larger loans generally benefiting from lower rates than small ones. Representative rates for each tier are as follows:

  • £1,000-£2,999 – Rates from 9.8% APR
  • £3,000-£4,999 – Rates from 7.8% APR
  • £5,000-£14,999 – Rates from 2.8% APR
  • £15,000-£25,000 – Rates from 2.7% APR

These are representative rates, which mean they’re offered to 51% of those who qualify for the product used in this explanation. This means they’re realistic, rather than the attention-grabbing headline rates that are often advertised online.

That said, the leading lenders tend to accept borrowers with a clean credit record, so if you’ve suffered adverse credit, you could end up paying more.

What are the main car loan types?

When it comes to loans, the car loan is the main type of loan used to purchase a vehicle. That said, there are other ways of financing a new car.

Car loans – Traditional personal loans aren’t secured against the car and allow you a greater degree of flexibility should you choose to sell or trade the car in the future. This is because the lender doesn’t have a legal interest in the car, despite lending you the money to purchase it. These loans can be broken down into refinance car loans, new car loans and used car loans.

Hire purchase – Hire purchase allows you to hire a car from your lender, paying an instalment each month until the car has been paid for in full. Once completely paid off, ownership of the car is transferred to you, and your agreement will your lender will end. When taking out a hire purchase agreement, you will usually be expected to pay a deposit towards the cost of the car.

Personal contract purchase (PCP) – PCP agreements work in a similar way to hire purchase agreements, however, at the end of the term, you have the option of paying a balloon payment or handing back the car. In addition, PCP contacts usually come with a designated maximum mileage that cannot be exceeded. The monthly cost of a PCP contract is usually lower than an equivalent car loan or hire purchase agreement, but that does come at the cost of a large balloon payment and reduced flexibility.

What is a refinance car loan?

A car loan refinance is simply a personal loan that is used to repay existing car finance. There are many reasons why somebody could choose to refinance a car loan including reducing their interest rate, reducing or extending their term, or switching from one type of car loan to another. As an example, a client may choose to repay their hire purchase agreement with an unsecured personal loan to increase their flexibility.

There are large differences in the interest rates charged by lenders such as AA and the Post Office, who offer auto loan refinancing rates from 2.7% and others at rates as high as 12-15%. As such, there are big savings to be made when refinancing your car loan, especially if your outstanding balance is large.

Anybody can refinance their car loan. The first thing to understand is exactly what your outstanding balance is, and from there you can compare products from other lenders and if you find a suitable offer, apply.

What is a used car loan?

A used car loan is a type of personal loan that can be used to purchase a used car. They are usually unsecured, meaning no formal security is taken over the vehicle that you buy.

Rates are usually between 2.7-15% APR, with larger used car loans and those for borrowers with a strong credit score being lower. 

Used car loans can be offered to anybody over the age of 18, subject to meeting the lender’s criteria. As mentioned above, these loans are unsecured, meaning any previous adverse credit, missed payments, defaults or CCJs negatively impact you.

These loans are arranged over a set term, usually between 2-7 years and are repaid through regular monthly payments. Each payment is made up of both interest and capital, which allows you to repay the loan in full at the end of the term.

What is a new car loan?

A new car loan is a type of unsecured loan that is used to purchase a new car. As these loans tend to be larger, you may benefit from lower interest rates than those available for cheaper, older vehicles. Rates start from 2.7% with an upper limit of 15% APR for most applicants.

As with other personal loan types, any borrower over 18 can apply, subject to meeting your chosen lenders criteria.

What are the car loan laws?

Car loans, as a type of personal loan, are a type of consumer credit, meaning that car loan rights are regulated by the Financial Conduct Authority (FCA). This offers some degree of protection to borrowers and importantly offers a route to resolve disputes where an agreement can’t be reached with your lender.

This dispute resolution service is called the Financial Ombudsman Service (FOS). The FOS look at the facts and circumstances of each complaint, listening to both sides before deciding what’s fair and reasonable.

Where a decision is made by the Financial Ombudsman Service, it is binding on the lender, but not the borrower.

What is the origin of car loans?

Car loans were first originated in 1919 by Alfred P. Sloan, President of General Motors when he set up the General Motors Acceptance Corporation. The need for financing was clear as the motor vehicle grew in popularity, as consumers often had to save for many years to afford a new car.

These loans were initially available in 5 large American cities, but due to their popularity, spread quickly across America. Other car manufacturers were quick to launch their own financing divisions on the back of the incredible success.

Early loans were arranged over a 12-month term and required a 35 per cent deposit in order to qualify.

Important car loan statistics

The industry is huge and car loan statistics are also so large that they’re often difficult to comprehend. According to the Finance & Leasing Association (FLA), new car finance in 2021 equalled £32 billion.

While in the first half of the 20th century, most vehicles were bought in cash, a staggering 93% of all new cars purchased in 2021 used finance. According to recent research, the average monthly car loan cost is between £300-400 per month, with more than 44.9% of those surveyed planning to spend more on their next vehicle.

In America, the total outstanding on auto loans was $1.18 trillion dollars.

What is car loan principal?

Car loan principal is a term used to describe the amount that you originally agreed to pay back. When adding the total interest due to the principal amount borrowed, you have the total cost of credit (TCC).

Your principal amount is the same as the amount you originally borrowed.

As this type of finance is taken out on a capital repayment basis, each month you are paying 

paying principal on a car loan as well as the cost of interest. This means the loan is repaid in full at the end of the term.