Auto Loan (Vehicle Loan)

Author: Noah Gomez

Published: 12 October 2023

Auto loans are consumer financial products used to fund the purchase of cars, minivans, normal vans, sport-utility vehicles, pickup trucks and other motor vehicles designed for personal use. Professional vehicle loans are referred to as business auto loans by necessity.

They usually last 48—72 months, require ~10% down, and charge 4%—8% interest. The average auto loan size is approximately $38,000¹.

Auto loans are not the same as title loans, which use borrower ownership in a personal vehicle as collateral for high-interest emergency funding and often engage in predatory practices.

The key cost driver on auto loans lender type. Financial companies provide lower rates than banks in 2023, but banks provided better rates until September 2022.

Consumers should also note that auto loans are not credit builder products despite growing use of the term "Credit Builder Vehicle Loans."

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Purpose

The purpose of auto loans is to enable consumer mobility by funding the purchase of a personal vehicle for which the borrower lacks comfortable cash reserves to purchase outright.

Popularity

Auto loans account for approximately 6% of consumer credit and 30% of consumer debt when excluding mortgages. There was a sharp increase in auto lending in 2021 after a slight decrease in the beginning of 2020.

That said, banks are reporting a decrease in demand in 2023, which is a likely cooling off period following the 2021—2022 spike.

Altogether, the data suggests auto loans will regress to the average and continue to hold 30% of consumers' non-mortgage debt balances.

The three graphs below demonstrate these dynamics using data from the U.S. Federal Reserve.

This graph shows the evolution of total auto loan balances in the market. In the 10 years from 2013 to 2023, total auto loans grew from ~880 billion to almost 1.6 trillion. That's a 74% increase in just a decade.

This pie chart shows auto loans as a percent of all consumer debt, excluding mortgages, for the 12 months ending June 2023. Auto loans represent 31% of the whole, with the remaining distributed across student loans, credit cards, personal loans, and other minor debts.

This chart shows the percent of banks reporting increased demand in auto loans. The trend is cyclical due to normal use of cars but shows the pandemic had a cooling effect in 2020, following by a spike in 2022 and subsequent regression to the mean in 2023.

Structure

Auto loans have 7 core components, shown below.

  • Principal amount
  • Term
  • Payment Terms
  • Interest
  • Fees
  • Annual Percentage Rate (APR)
  • Collateral

#1 Principal amount

Principal amount is the dollar value distributed by the lender to the car buyer. It is not the same as the vehicle price because down payments can reduce funding needed.

This is known as Loan-to-Value (LTV), where loan is the amount of debt and value is the market price of the vehicle. An average LTV is 90%.

The average principal loan amount is about $38,000 in 2023. This graph displays the evolution of principal amount from just under $26,000 in 2013.

#2 Term (Maturity)

Auto loan term is the number of installments the borrower makes to payoff the principal amount, usually measured in months. The most common auto loan terms are 48, 60 and 72 months.

The graph below highlights that the average loan term is consistently between 62 and 71 months over time, with an average of 66 months from 2013 to 2023.

#3 Payment Terms

Payment terms specify the frequency of payments. Auto loans almost always have a monthly cadence. Some lenders may allow quarterly or bullet payments, which refers to paying the full amount in one "shot" at the end of the loan term.

#4 Interest Rates

Interest rate determines the cost of borrowing money to purchase a vehicle. They are usually the most important decision making criteria for borrowers.

Interest rates are driven by duration. Shorter durations have lower interest rates. This correlation is illustrated in the graph below.

#5 Fees

All closed-end credit loans have administrative costs called origination fees. For auto loans, they typically range from 1% — 2% of the principal amount.

Origination fees are deducted from the principal amount at distribution, so borrowers should ensure they have an additional ~2% in liquidity in addition to the down payment at signing.

#6 Annual Percentage Rate (APR)

Annual Percentage Rate (APR) is not the same as interest rate. Interest rate is the percent charged within the monthly payment schedule, whereas APR is a separate figure that computes the total interest and fees as a percent of the principal amount, normalized to 365 days.

APR allows borrowers to compare rates from different lenders for different durations. However, it can be deceptive. The image below shows how a 10% interest rate is constant and APR decreases over longer loan durations. The total cost of interest, however, grows by nearly 4 times.

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#7 Collateral

Collateral in an auto loan is the vehicle itself. In the case the borrower defaults on the loan, the borrower can repossess the vehicle. This right to repossession is what allows lenders to offer lower average rates than other loan types, such as debt consolidation and personal loans.

Secured Loans

Because they use the vehicle as collateral, auto loans are secured. Secured loans have lower rates and more flexible terms than unsecured options because they carry less risk for the lender.

Loan Provider a Key Decision

Cost is a key factor for most car buyers, and the cost of borrowing is interest. In addition to duration, the lender type has a strong impact on rate. Historically, banks offer lower rates than financing companies, who do not have deposits to fund their lending activities.

In recent years, however, financing companies offer rates a full 1% lower than banks. The graph below illustrates the difference over time.

Seller Financing

Car sellers often offer financing in-house. Borrowers should keep in mind that sellers resell the loan to banks after origination for a profit, which means the borrower pays a premium for the middleman service.

Lender Financing

Commercial banks and financing companies usually offer better rates than sellers. This is because they originate and administer the loan, which means there is no premium for middleman services.

Recourse & Renegotiation

A recourse auto loan allows the lender to pursue assets other than the vehicle in the case of borrower default. Almost all auto loans are recourse, so the borrower should be aware that the consequences of non-payment do not end with vehicle repossession.

Renegotiation loans are those that allow the borrower to request modification to loan terms, usually interest rate. Auto loans can be renegotiable, but the choice is at the lender's discretion.

Most sizeable lenders allow renegotiation because the borrower can otherwise pursue another lender to repurchase the loan.

Auto vs. Title Loans

Auto loans provide funds for the initial purpose of a vehicle, whereas title loans provide a high-interest using ownership in the car as collateral.

For example, imagine a consumer wants to purchase a $10,000 truck. He puts $1,000 down and takes an auto loan for $9,000 at 6% interest for 60 months. After 1 year, he has paid $1,591 in principal and now owns $2,591 ($1,000 down + payments) in the truck.

He has an emergency and needs to borrow $500 for 2 weeks until he receives his pay check. He takes a title loan for $500 by pledging the ownership in his car.

In reality, title lenders avoid borrowers who don't own their vehicle outright. The above example is an illustration of the difference between each type.

Credit Building Auto Loans

Several credit unions market auto loans available to subprime lenders as credit building opportunities. Strictly speaking, these are not credit building products because their purpose is not strictly to improve consumer credit.

That said, they work by establishing high interest rates that slowly drop with on-time payments. These options can be a good choice for consumers who have poor credit but strong cash reserves and need a vehicle.

Target Markets

Auto loans are available in virtually every economy that depends on motor vehicles, which is effectively the entire world. That said, auto loan lenders are particularly present in countries with a large number of new car purchases, such as developed Asia, Europe and Anglo-Saxon countries like the UK, Australia, New Zealand, Canada, and the United States.

Citations

  1. “The Fed - Consumer Credit - G.19.” 2019. Federalreserve.gov. 2019. https://www.federalreserve.gov/releases/g19/current/default.htm.

Nice to Know, Thanks

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About the Author

Noah Gomez (founder of Thick Credit) is a transatlantic professional and entrepreneur with 3+ years experience in consumer finance education. He also has 5+ years of experience in corporate finance, including debt financing, M&A, listing preparation, US GAAP and IFRS.

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