Car Loan

What It Means

A car loan (also known as an automobile loan, or auto loan) is a sum of money a consumer borrows in order to purchase a car. Generally speaking a loan is an amount of money that is lent to an individual, a business, or another entity. The party that lends the money is known as the lender, while the party borrowing the money is called the borrower. When taking out a loan a borrower agrees to pay back the full loan amount, as well as any interest (a percentage of the loan amount, usually calculated on an annual basis), by a certain date, typically by making monthly payments.

Car loans follow most of the same rules and procedures that apply to other loans. In most cases when purchasing a car, a borrower will specifically apply for a car loan; however, a consumer can also use a personal loan (a loan obtained by an individual to use at his or her discretion) for the same purpose. All car loans are for specific lengths of time, generally anywhere between 24 and 60 months, although some car loans can be for longer periods. This type of loan is also known as financing. Car loans generally include a variety of fees and taxes, which are added to the total loan amount.

Many consumers apply for car loans at their local bank. When applying for a car loan a borrower will usually begin by specifying how much money he or she wants to borrow. The borrower will then provide information about his or her financial situation, beginning with income (the amount of money he or she earns by working). Most lenders will require the borrower to provide some proof of employment, usually in the form of a pay stub (the portion of a paycheck that includes information about an employee’s earnings, which an employee keeps for his or her records) or a copy of a tax return (the form submitted by individuals when paying taxes). The lender will also check the borrower’s credit report. A credit report is a detailed record of an individual’s past credit (in short, borrowing) activities, whether in the form of loans or other debts (money owed). If the prospective borrower has a bad credit history, he or she may be ineligible for a car loan.

Often a bank or financial institution will preapprove certain customers for car loans. In these situations a consumer has a certain number of days (often 30, sometimes 45) to decide whether to seek full approval for a car loan. Because most borrowers secure a car loan before actually shopping for a car, when an application for a car loan is approved, a lender will generally give the borrower a maximum amount he or she will be able to borrow. The borrower is then free to use this money to purchase the car of his or her choosing; however, the borrower is not required to spend the full amount offered by the lender. For example, while a bank might approve a car loan of $50,000 for a long-term customer, that customer has the right to spend only a fraction of that amount.

When Did It Begin

The car loan officially originated in 1919, when the General Motors Corporation (an automobile manufacturer founded in 1908 in Flint, Michigan) established the General Motors Acceptance Corporation, or GMAC. GMAC arose in response to the growing demand for automobiles among American consumers after World War I. In 1919 GMAC established offices in five North American cities; a year later it opened its first office in Great Britain. As the car loan business expanded, other automobile manufacturers began to develop their own financing divisions. One of the most prominent was the Ford Motor Credit Company, founded in 1923. Although car loans were available most American consumers during the first half of the twentieth century paid cash for their automobiles.

More Detailed Information

When a borrower takes out a loan on a car, he or she is agreeing to buy the car. Upon entering into the loan agreement the borrower gains the right to drive the car, while also taking possession of the car’s title (a document showing proof of ownership of a piece of property). Technically speaking, however, the borrower does not yet own the car; the lender owns the car until the borrower has finished paying off the loan.

Each car payment consists of two parts: the principal (the original amount of the loan) and the interest. Interest on car loans depends primarily on three main factors: the credit rating of the car buyer, whether the car is new or used, and the price of the car. As a rule interest rates on new cars tend to be lower than interest rates on used cars. Also, as the price of a car goes up, the interest rate will usually go down. For example, if a consumer wants to purchase a used truck listed for $2,500, the loan interest rate might be 6.49 percent; if that same consumer wants to purchase a new $40,000 Lexus, the interest rate might only be 5.49 percent.

The bulk of a monthly car payment goes toward the principal, so that the total amount of the loan decreases steadily with each payment. As a borrower pays off more of the principal of the loan, he or she moves closer to full ownership of the car. The amount of money the borrower has paid toward full ownership is known as equity; in other words with each loan payment the borrower earns additional equity in the car. At the same time, the value of the car steadily decreases over the course of the loan, meaning that the car will never be worth the amount of the original loan. For example, say a borrower takes out a $10,000 loan to pay for a car. At the time of purchase the car is worth about $10,000 (minus fees and taxes). Four years later, when the borrower has paid off the loan, the car may be worth only $2,000. If the borrower has neglected to take good care of the car, it might be worth substantially less. This process by which the car loses its value over time is known as depreciation.

Traditionally car loans were for short periods, generally about 24 months and no longer than 36 months. In the 1980s, however, standard car loan periods began to get longer. There were two key reasons for this change. For one, in the early 1980s more and more consumers began to lease their cars (they paid a monthly fee in exchange for the right to drive a particular car) rather than purchase cars outright. Car leases were primarily attractive because they did not require a down payment, and they tended to require lower monthly payments than traditional car loans. In order to compete with the car leasing industry, a number of lenders began to offer car loans for longer terms. As a result loan periods of 48, 60, and 72 months became standard. In some cases borrowers were able to receive even longer periods over which to repay their loans. For example, when a borrower purchases a luxury vehicle (a car, a truck, or another vehicle that is more expensive than average cars and generally includes additional features designed to increase car performance or comfort), he or she will sometimes have as long as 84 months to repay the loan. In the early twenty-first century a luxury car was generally defined as a vehicle costing in excess of $30,000. From the early 1990s to the middle of the following decade, the proportion of Americans who owned luxury cars rose from 10 to 30 percent. This overall rise in the price of motor vehicles was the second significant reason that standard car loans became longer in duration.

Recent Trends

As with a number of other types of loans, car loans have become increasingly available over the Internet since the late 1990s. There are many advantages involved with shopping for car loans online. For one, shopping for loans online allows consumers to compare interest rates from a wide range of lenders, in a relatively short amount of time, therefore giving them a better chance of securing the best deal. Also, because online car loan companies require little cost overhead (the expenses involved with running a business, including renting an office, paying employees, buying office supplies, and so on), they can often offer consumers lower interest rates than those offered by traditional banks.