Lenders secure car loans by using the vehicles as collateral. The lender has the right to repossess the car if the borrower defaults on the loan. Some people use unsecured personal loans to buy cars, but if a borrower of a personal loan defaults, the lender has no ownership rights to the car.
Financing a Car
Prior to securing a lien against a car, the lender must determine the worth of the vehicle used as collateral. Generally, lenders use car values listed in the Kelley Blue Book. KBB shows prices for cars based on make, model, age, condition and local market price. Some car dealers attempt to sell cars for prices far above of the true value, but lenders base loan approval on the value of the car, not the sale price. Lenders typically do not write loans for amounts in excess of the car's value.
Securing a Lien
When you take out a car loan, the lender places a lien on the vehicle. The lender files the lien at the local courthouse or department of motor vehicles, and it stays on file until you fully pay it off. After the lender receives your last loan payment, he releases the lien. This usually involves a bank employee signing the car title to show that you paid off the loan. At that point, you gain full ownership.
Gap Insurance
Cars lose value over time. To prevent owners from reaching a point where the loan balance exceeds the car's value, most lenders limit car loan terms to five or six years. However, even within a few years a car's value can drop rapidly. If the owner crashes the car, the insurance company only covers the cost of loan. This means the borrower pays the difference between the loan amount and the car's value. Some lenders require borrowers to obtain gap insurance, which covers the difference between a car's value and the outstanding loan amount.
Lender's Risk
A lender can repossess a car if a borrower defaults on the loan. But since cars are mobile, they are much harder to repossess than homes. To reduce the risk associated with car loans, most lenders only write them for people with credit scores above 640. Additionally, borrowers must have sufficient verifiable income to make the monthly payments and still have funds to cover their other debts.
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