How Does Car Credit Work?

Cars can cost thousands of dollars, especially a brand-new vehicle, so buyers typically finance them to spread out repayment over several years. A car loan is a type of credit which you must apply and qualify. The automobile acts as security for the debt, so there are some special provisions for defaults.

Loan Type

Car credit falls into the installment loan category, according to Teri Cettina of the Bankrate financial site, unlike credit cards that have variable repayment schedules. You borrow a certain amount of money that covers the car purchase. The loan runs for a set number of years, typically between one to five years or more, with the same payment amount every month. You must pay off the loan in a lump sum if you sell the vehicle before the end of the loan term.

Loan Sources

Many sources offer car credit, including dealerships, banks, credit unions, finance companies and online lenders. Dealers do not actually provide the money; they act as intermediaries, finding loans for their customers. A dealership-arranged loan has some profit built in for the dealer, according to Capt. Robert Luyties of the U. S. Army's Fort Leonard Wood Legal Assistance office, so you can find better terms on your own. Financial institutions are often willing to pre-approve you so you can negotiate your car price without worrying about whether you will qualify for the loan.

Considerations

Vehicles lose their value quickly, so you may become "upside down" on your loan, meaning that you owe more than your car is actually worth. This dilemma is particularly common for lengthy loans. Avoid it by financing your car for the shortest possible term and putting down a high deposit. Never get a loan for more than 42 months, consumer advocate Clark Howard's website recommends. Otherwise you will have to come up with extra cash if you sell or trade-in your car, or roll the upside-down amount into your new auto loan, which compounds the problem.

Co-signed Loan

Automobile buyers with little or no established credit files, or those with bad credit, can use a co-signer to qualify for car credit. This person, usually a family member, agrees to be fully responsible for the debt if you default on it. Your payment history affects the co-signer's credit records, MSN Money writer Mary Rowland warns, so you can destroy their good standing if you do not handle your car loan responsibly.

Warning

Car credit contracts typically have a provision allowing your lender to repossess the vehicle as soon as you default, the Federal Trade Commission advises. Some lenders will take the car if you miss a single payment. The repossession team usually can seize your vehicle from private property, depending on your states' laws. The bank then sells the car and holds you responsible for any difference between the sale amount and owed balance. For example, if you owed $5,000 and the car sold for $3,500, you are liable for the remaining $1,500.