A car purchase is one of the most significant financial decisions people ever make. If you’re in the market for a new or used vehicle but don’t have the funds to pay in full, consider taking out an auto loan. It allows you to get into the driver’s seat of your long-awaited car right away. All that’s left is to keep up with monthly payments. However, is it really that simple?
Before you sign a loan contract, you need to know how car loans work, the different types available, and the specifics of the application process. Find out how to finance your vehicle with a car loan.
What is a Car Loan?
A car loan is a lump sum of money you borrow from a lending party — a bank, a credit union, private lenders, or other financial institutions — to secure funds for the car purchase.
It consists of the borrowed amount, known as the principal, fees, and interest. You pay off the loan by making regular monthly payments, part of which goes toward the interest, while the remainder covers the principal.
Car Loan Types
When choosing how to finance your vehicle, explore available options and how they differ. Here’s a brief description of available car loan types:
Secured vs unsecured car loans. If you opt for a secured car loan, your vehicle becomes collateral. The lender can seize it if you default on monthly payments. Typically, a secured car loan has a lower interest rate and higher borrowing limits. In parallel, an unsecured loan isn’t backed by any valuable asset. Your eligibility depends on your credit report, credit score, and your assessed ability to repay.
Fixed vs variable interest auto loans. With fixed-rate loans, your interest rate stays the same for the entire loan term. That is, your monthly payment remains consistent and predictable. Conversely, a variable-rate loan changes over time, with interest rising or falling based on the lender’s prime rate.
How Do Car Loans Work?
A car loan works similarly to other personal loans. Once you’ve decided what automobile you’d like to purchase, it’s time to fill out an application form. The borrower can apply through banks, credit unions, private lenders, or directly at the dealership. When financing through a dealership, you can request your car loan to be with Innovation specifically to secure competitive rates and better terms.
Most auto loans are secured. This means the lender places a lien on your vehicle and has a legal right to repossess it if you fail to keep up with regular car loan payments. The lender will also review your credit history to verify your creditworthiness. Your credit score will also have a considerable impact on the interest rate you’re likely to be charged.
Note that some car loans don’t require a down payment. However, it’s recommended to make a payment of anywhere between 10% and 20% of the vehicle’s value. The larger the initial deposit you put toward the purchase, the smaller the sum you have to borrow and the lower the interest you’ll have to pay over time.
Auto Loan Eligibility Requirements
The eligibility criteria for a car loan vary across lending parties. Still, you have to meet some standard requirements, namely:
Be a Canadian resident.
Have a valid Canadian driver’s license.
Be 18 or 19, depending on the legal requirements in your province or territory.
Meet a minimum income requirement set by your lender (lenders require documentation such as pay stubs to prove your income).
Have a good credit score (your credit report will determine the interest rates and approved amount of your loan).
If you’re doubtful about whether you meet the eligibility requirements to qualify for a car loan, applying for a pre-approval or pre-qualification can make things clearer.
With a pre-approval, the lender reviews your debt-to-income ratio, credit report, credit score, and other relevant information to determine what size of a car loan they could approve for you and at what interest rate. Note that pre-approval typically necessitates a hard credit inquiry, which might temporarily decrease your credit score.
Prequalification usually entails a soft credit inquiry, which doesn’t affect your credit score. As pre-qualification doesn’t delve that deep into your financial standing, the estimates on how much you could borrow and at what rate will be less accurate than with a pre-approval.
Remember that none of these processes guarantee you will receive a car loan.
Common Car Loan Terms
When choosing a loan to finance a new or used car, pay close attention to the loan term length. It’s the time within which you must repay the borrowed amount. Most lenders in Canada offer loans ranging, on average, from 2 to 6 years. Still, some lenders may extend terms up to eight years. The term depends on the lender’s policies, your credit profile, and the amount you’re borrowing.
Keep in mind that shorter terms allow you to save on interest over the life of the loan. However, they make for larger monthly payments. In contrast, a longer term might seem more appealing due to lower monthly payments. However, it leads to higher overall interest costs.
Power of Interest
Let’s illustrate the cumulative power of interest and its effect on the total cost of the loan. Suppose you’ve opted for a $30,000 auto loan at a 2,75% interest rate.
You have two car loan options with identical amounts and interest rates. The only difference between the two options is their duration: three years or six years.
When estimating the total cost of a vehicle loan, it’s critical to account for the annual percentage rate. The rate includes the interest and any extra fees.
Here’s a breakdown of what to expect in terms of the total interest paid (without fees):
Car Loan Term | Monthly Payment | Total Interest Paid |
36 months (3 years) | $902 | $2,475 |
72 months (6 years) | $485 | $4,950 |
With a shorter 3-year term, you’ll have to provide almost twice as much for a monthly payment. While a 6-year term seems enticing due to lower monthly payments, you’ll pay almost twice as much interest as with a shorter-term arrangement.
Requirements for a Car Loan
To ensure your loan application gets approved, consider some of the common requirements:
Proof of residence and identity. You’ll have to hand in a government-issued ID alongside utility bills to prove your identity and Canadian residence.
Driver’s license. You’ll need a valid driver’s license to purchase an automobile.
Proof of stable income. Expect to be asked to provide recent pay stubs, bank statements, tax returns, and employment history to verify your current income level. The specific income bar varies across lenders and depends on the requested car loan amount and your debt obligations, i.e., existing loans. In Canada, most lenders have a minimum income requirement within the $1,200-$1,800 range.
Good credit score. A decent credit score for a car loan (600 and higher) improves your chances of approval. Most lenders review your credit history and credit report thoroughly to ensure you can repay the borrowed sum.
Down payment. This is an optional requirement that may or may not be included in your loan agreement. In most cases, a higher down payment amount is a good strategy to increase your chances of getting approved for a car loan. It will also lower your interest payments.
Where to Get a Car Loan
There are three trusted ways to get a car loan in Canada:
Credit unions or other financial institutions. Traditional lending institutions such as banks and credit unions tend to have stricter car loan eligibility criteria, which makes them a good option if you have a good credit history. Conversely, if your credit score isn’t exemplary, getting approved might be more challenging. You can also refinance a car loan on more favorable terms through these institutions if your credit health has improved or your Debt-to-Income ratio decreased.
Dealer financing. You can borrow funds for your vehicle through dealer financing directly at the point of purchase. Dealers act as intermediaries assisting their customers in arranging financing with a car manufacturer, a financial institution like Innovation, or an independent lending party. This is a great option for those who want to buy and secure funds for their car all in one spot.
Online lenders. Many private lenders offer online car loan services. With this option, you can apply, get approved, and sign an agreement using your device. Note that online loans might be riskier as they come with higher interest rates, making it more challenging to manage monthly car payments.
Closing Thoughts
A car loan is a tool to finance a new or used vehicle. Start by comparing offerings and paying close attention to the lender’s requirements and general eligibility criteria. Consider getting quotes from multiple lenders to ensure the selected car loan fits your monthly budget and overall financial objectives.
If you’re hesitant about what car loan to opt for, our financial experts are glad to help. Contact us today for a consultation.