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How Car Loans Work in Canada

By Heidi Unrau | Published on 27 Jul 2023

How Car Loans Work

    Have you seen the price of cars lately? You should sit down for this; the average price of a used car is over $35,000! The thought of credit checks, big money numbers, and financial commitments just went from exciting to terrifying, especially since we didn’t learn how car loans work in school. And not all car loans are created equal either. Wait, they’re not? Don’t stress! Here’s the lowdown on how car loans work in Canada so you can hit the open road with confidence.

    How do car loans work?

    A car loan is a type of personal loan used to finance the purchase of a car without having to save up stacks of toonies yourself! In most cases, the borrower uses the vehicle they’re purchasing as collateral to secure the loan. The borrower then agrees to make payments over a specific period of time with interest.

    Interest on a new loan for a car can range anywhere from 7.21% to 20% and repayment terms typically last anywhere from 1-7 years. Getting a car loan can be a cost-effective way to finance your ride to Tim Hortons – I mean work, or wherever you need to go. But for that statement to be true, you need to understand how car loans work and if you can actually afford one. 

    Why are car loans important?

    Owning a car isn’t always a luxury, sometimes it’s a necessity. Not only is Canada a massive country, but not all of us can afford to live close to work or the amenities we need. And we can’t all walk to the grocery store or access public transportation. 

    Millions of Canadians rely on car loans to access safe and reliable transportation by spreading the cost of a car purchase over an extended period of time. That makes it easier for many people to afford a new or used vehicle when they need one. Unfortunately, not everyone understands how car loans work. I mean, they don’t exactly teach us this stuff in school.

    Most car loans in Canada come with fixed interest rates that protect you from any changes in the market, giving you predictable monthly payments and peace of mind. Car loans can also help people with less-than-stellar credit improve their scores over time by demonstrating positive repayment behaviour. 

    Car loan jargon you need to know

    When it comes to car shopping and financing a loan, you can’t make an informed decision if you don’t understand how car loans work or what you’re agreeing to. Before we jump in, let’s break down common car loan jargon in a language we can actually understand. 

    APR

    This stands for the Annual Percentage Rate (APR). The APR is like your ex’s Instagram account, it gives you the whole picture of how much you’re spending in the long run. You might notice the APR is higher than the interest rate in the contract. That’s because it includes other charges, like fees, to show you the total cost of borrowing over the life of the term. 

    Amortization

    Next up, we have the amortization period, which is the length of your loan expressed in years or months. It’s like a Netflix series, the longer it is, the more time you spend on the couch, but worse. The longer your car loan amortization period is, the lower your monthly payments will be, but you’ll end up spending a lot more money in the end. A 7-year car loan will cost you significantly more money than a 5-year car loan because you’re making interest-bearing payments for an additional 2 years.  

    Co-signer

    A co-signer is like a wingman, they take responsibility for the loan with you, especially if you don’t have a good credit score. But sometimes friends and money don’t mix, so make sure you trust each other before you ask them to sign on the dotted line. They’re taking on a huge risk that you could bail on the loan, stick them with the payments, and even wreck their credit – so respect that.

    MSRP

    MSRP stands for Manufacturer’s Suggested Retail Price, which is the price that the manufacturer recommends for their new car models. It’s important when financing a car loan because it serves as a baseline for lenders when determining how much money to lend to you. The MSRP functions like a “cap” on the amount of money that can be loaned, which helps protect both you and the lender from over-borrowing or taking on too much debt.

    It also serves as an indication of how much to expect for trade-ins and other incentives offered by dealerships. For example, if the car you are interested in costs less than its MSRP, you may be able to qualify for additional savings or better financing terms from your lender. Knowing the MSRP can help you get more bang for your buck – and I love me some good money-saving tips!

    Pre-approval

    Pre-approval is like getting a match on a dating app, it means a lender thinks you’re worthy of a loan, but it’s not a guarantee that you’ll actually get it. So read the terms and conditions, just like you creep Facebook profiles before meeting up.

    The vibe-check

    Ok, this isn’t a car loan term, but it’s something you should always do before making any financial decision. Don’t be afraid to ask questions and do your research. A credible lender will create a judgment-free safe space for you to ask “dumb” questions to understand the nuts and bolts of the offer. If the lender is evasive, standoffish, or pushy, then walk away – it’s a red flag. If something in the contract seems off, get a second opinion.  

    Types of Car Loans in Canada

    Car loans are an important part of the Canadian consumer landscape. With so many options, it can be difficult to know which one is right for you. Below are the most common types of car loans and how each car loan works:

    How car loans work when secured

    The most common type of car loan in Canada is a secured loan. This type of loan requires collateral, usually the car itself, and is generally easier to get than an unsecured loan. A secured car loan typically comes with lower interest rates than unsecured options because borrowers are less likely to default on payments. Why is that?

    A secured car loan is like having your mom chaperon your date. If things go south, mom (lender) takes the fancy car (collateral) away from you. It’s humiliating and hell on your credit score, so you’re more likely to do everything you can to keep your loan in good standing. 

    How car loans work when unsecured

    An unsecured car loan is a type of loan that does not require collateral, like the car itself, to secure the loan. It usually comes with a higher interest rate than a secured loan, and shorter repayment periods. An unsecured car loan is a good option if you don’t want to run the risk of your car being repossessed, but it can be harder to get if you don’t have good credit.

    Think of it this way: an unsecured car loan is like getting your own place. Sure, it’s more expensive (interest), but mom (lender) can’t snatch your whip. It’s typically better for used/less expensive cars or if you want more flexible repayment options. Of course, the finance journalist in me would be remiss if I didn’t tell you to avoid higher-interest loans at all costs unless you have no choice.

    How car loans work for s new car purchase

    Loans for new cars (not previously owned) tend to let you borrow a larger amount at lower interest rates than used car loans. That’s because lenders are more confident they can recoup any money they lend when a customer purchases a brand-new vehicle as opposed to a used one. Newer cars also tend to have longer, more robust warranty periods which provide additional security for both the lender and borrower in case something goes wrong.

    How car loans work for a used car purchase

    When it comes to used cars, lenders may not be as willing to offer such large financing amounts or low-interest rates. That’s because of the potential risks associated with older cars. In most cases, these types of loans will also come with shorter repayment terms than those offered on new car loans.

    How car loans work with a trade-in

    Trading in your old car for a new one can be a part of the car-buying process in Canada. In this situation, the dealership purchases your old car and the value is typically applied as a down payment on your new or used vehicle. This can help to reduce the amount of money you need to borrow and therefore lower your monthly payments. You can finance a trade-in through a traditional lender, dealer financing, or a private lender – but dealer financing tends to be the most common way to finance a trade-in.

    However, if you still owe money on the car you’re trading in, the process becomes more complicated and expensive. In this case, the lender will pay off your existing loan and add any remaining loan balance to the loan for your new car. When you owe more on your current vehicle than what it’s worth, this is called being “upside down” and the remaining loan balance is known as “negative equity.”

    Rolling over the negative equity from your old car loan does not make the remaining balance disappear – it simply moves it into your new loan. You’ll still be responsible for paying it off, and you’re more likely to be “upside down” on your new loan as well. As a result, you should try to pay off your existing loan before trading in your car, if possible.

    Types of Lenders: which one is right for you? 

    Choosing a lender to finance your car loan is like scrolling for the next binge-worthy Netflix show – there are just so many options. Traditional lenders usually have the best rates. The dealerships hype special discounts and flashy freebies. And then there are the wildcard private lenders who often say yes when the others say no. Here’s what to know: 

    Traditional lenders

    A traditional lender, like banks and credit unions, is like your best friend’s mom.  They’ve been around for a long time, they know what they’re doing, and they’re trustworthy. These lenders usually have the lowest interest rates, but the application process can be strict and time-consuming.

    Traditional lenders prefer lending to people with good credit scores, steady employment, predictable income, and not much debt. In other words, if you’re credit challenged, self-employed, or your income fluctuates a lot (hello gig economy!) you’re more likely to be turned down. Bummer.

    Dealer financing

    The dealership is like a party host, they’ll get you a loan for the car you want, but they’re going to charge you for it. Dealer financing usually comes with higher interest rates and additional fees. On the upside, the application process is usually faster. However, buyer beware

    Dealerships might distract you with deals that aren’t really deals (like 0% financing, more on that later), and slick number crunching. They’re more likely to push a loan offer based on your desired monthly payment instead of the purchase price – which obscures what you’re actually paying for the car. The size of your monthly payment in no way reflects the total cost of borrowing – which includes the car’s total purchase price, interest rate & fees, and amortization.

    Private lenders

    A private lender is like a stranger you meet at a party. They’re not as well-established as the other options, and they might not have the best reputation, but they’re willing to take risks. The interest rates can be very high and the terms may be less favourable, like early payoff penalties and other ancillary fees.

    Having said that, private lenders are much friendlier to people who are self-employed, have bad or no credit, and have unusual or unpredictable income. If the bank says no, a private lender can help get a car loan if you have bad credit or an unconventional financial situation.

    A word on new car “deals”

    Purchasing a shiny new car from a dealership can be super exciting and an easy way to get the vehicle you want, often with additional incentives. Before you sign on the dotted line, it’s important to understand the pros and cons of new car deals from dealerships.

    One of the biggest benefits of these types of deals is that they can offer you an attractive incentive, like 0% interest financing or cash back from manufacturer rebates, which lowers the purchase price of the car. That’s great if you don’t want to clean out your savings account to buy a car, or need more time to pay off the loan without paying more interest.

    Having said that, there are a couple of downsides to these deals. For starters, 0% interest and manufacturer rebates usually require you to have good credit in order to qualify. And they’re more likely to come with stricter repayment terms than what you could get from a traditional lender. 

    On top of that, some dealerships may offer “guaranteed approval” but that’s not as ego-boosting as you think. This type of promotion almost always comes with higher interest rates and other hidden fees.

    Make sure you always carefully read the offer details and fine print before signing any contracts so you fully understand what you’re getting into. With the right research and comparison-shopping between lenders, you can get a great deal on your car purchase!

    Leasing vs. financing 

    Getting a loan is one way to finance the purchase of a car. Another popular financing option is a lease. Buying a car with a loan is like buying a house with a mortgage. Whereas leasing a car is like renting an apartment. They both offer two very different ways of getting behind the wheel of a car, and each has its own set of pros and cons. Let’s explore leasing vs buying a car with a loan:

    Financing

    Using a loan is the most common way to finance a car because it allows you to pay off the total cost of the car over time (with interest!). The obvious benefit is that you own the car outright after the loan is paid off. The downside is that the monthly payments are usually higher and you are solely responsible for any repair costs that fall outside of a warranty.

    Leasing

    Leasing a car offers similar benefits to financing for those who don’t want to make a long-term commitment or purchase a new vehicle outright. It also comes with some added perks, such as lower up-front costs, access to more features, and lower monthly payments than if you were to finance the purchase with a loan. 

    However, leases often come with mileage restrictions which can add additional costs if you put too many miles on the car during your lease term. Another downside is that there are usually restrictions on modifications and upgrades that can be made while leasing the car because you don’t actually own it. At the end of the lease term, you have to give the car back unless you can afford to buy it out. 

    Which one is right for you?

    In a surprising turn of events, most Canadians are actually better off leasing. I know, my mind was blown too. Leasing makes the most financial sense if you don’t have to drive a lot or take long trips in your car. The key is understanding how car leasing works and choosing the right lease agreement for your needs and driving habits. 

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    Credit scores impact how car loans work

    Your credit score impacts your car loan options. This 3-digit number will tell lenders how financially responsible and creditworthy you are, which impacts your interest rate.

    The higher your credit score is, the more likely you are to get larger loan amounts and better terms than if you had a lower credit score. This typically includes lower interest rates or smaller down payments required upfront.

    A good credit score can also help you negotiate better rates with dealerships and traditional lenders (who already offer lower rates). That’s because your credit score tells them you have a track record of managing your money well, which makes you a less risky borrower than someone with a low credit score. These institutions are more willing to negotiate better terms for you as an incentive for taking on less risk.

    What credit score do you need for a car loan?

    Generally speaking, you need to have a credit score of at least 600 in order to qualify for a car loan in Canada. Unfortunately, lenders think people with higher credit scores are more financially responsible than those with lower scores. That’s not always true, though. 

    But don’t stress, you can still get a car loan with a lower credit score depending on your circumstances. If you’re willing to give a larger down payment or accept higher interest rates, you’re more likely to get approved. 

    And if traditional lenders turn you away, you still have options. Remember, private lenders have different qualification requirements and the specific details of your situation will play an important part in determining whether or not you can get a car loan. 

    Can you afford a car loan?

    Before you apply for a car loan, make sure you can even afford it. Besides your monthly payment, there are other costs to consider before getting a car loan. 

    Insurance

    It’s illegal to drive without car insurance in Canada, so you’ll need to factor that into your budget. To save money, compare car insurance policies from different providers to find the right coverage at the right price. It also helps to buy a car that is cheaper to insure

    Maintenance & repairs

    There’s also the cost of gas, regular maintenance, and surprise repairs. And since we’re in a frozen wasteland, you need to prepare for our ridiculously cold winters with winter tires and a block heater, if necessary. Trust me, you don’t want to be stranded on the side of the road in -40 degree weather, or trapped at home because your car won’t start. 

    Have you crunched the numbers?

    Use a car loan calculator to estimate your monthly payment to see how much money you have left after all your living expenses and debt obligations are paid. Can you comfortably afford gas and regular oil changes? Do you have enough savings to cover a flat tire, bent wheel, or the deductible on an insurance claim? 

    Finally, shop around and compare loan offers from different lenders. Getting the lowest interest rate possible will save tons of money over the life of your loan. 

    The golden rule of car shopping!

    You date the rate but you marry the purchase price. Negotiate the best possible deal on your car. A lower purchase price means a smaller loan, fewer interest charges, and more room in your budget for the things that matter. Good luck, and stay savvy!

    Where to find the best financing terms

    When it comes to buying a car, it can be overwhelming if you don’t know where to start when it comes to financing. That’s where Car Loans Canada comes in. Their online platform simplifies the process by connecting you with reputable lenders from across Canada who offer competitive rates and terms. With educational resources on everything from budgeting to negotiating with dealerships, you can feel confident making an informed decision about your next vehicle purchase.

    How to apply for a car loan

    Applying for a car loan in Canada is pretty straightforward. Here are the steps you should take to ensure that you get the best possible deal on your loan:

    1. Check your credit score and make sure it meets the lender’s requirements.
    1. Shop around and compare lenders before making any decisions. Online lenders like Car Loans Canada work with all credit types, and a site like Clutch can help you find an affordable used car and they offer in-house financing.
    1. Gather all the documents you need to apply, such as government-issued identification (ID), proof of income, proof of residence, and bank statements.
    1. Apply online, or contact the lender or dealership and provide them with all of your necessary information.
    1. Fill out the application form with details about yourself, your financial situation, and any special circumstances that may affect your loan approval.
    1. Wait for an approval decision.
    1. If approved, carefully read through the terms of your loan so you understand what is expected of you moving forward.
    1. Sign the contract if everything looks good.

    Tips for success

    1. Try to increase your credit score before applying. This will give you access to better deals as well as more choice when looking at lenders.
    1. If possible, try to provide a larger down payment. This will reduce your monthly payments and save money on interest in the long run. Plus, you’ll be debt-free sooner!
    1. Make sure to carefully review all contracts before signing so there won’t be any surprises once the loan is approved.

    Repaying your car loan & tips to save money

    Paying off your car loan is an important part of being a responsible car owner. Here are some tips and tricks to help you save money over your repayment term:

    Make your payments on time: avoiding late fees will not only save you money now but later too. Late or missed payments have a negative impact on your credit score which leads to higher rates and fees on future borrowing. It could also cause you to get rejected by lenders. 

    Set up auto-payments: this makes keeping up with your monthly payments easier and helps avoid any late or missed payments.

    Consider a shorter loan term: while this means higher monthly payments, it also means paying less interest over the course of the loan repayment period. And you’ll be debt-free that much sooner. 

    Pay more than the minimum monthly payment: this will help you pay off the loan faster and reduce how much interest you pay overall.

    Get pre-approved for refinancing: just because you got a crappy interest rate doesn’t mean you’re stuck with it! Shop around for lower rates and if possible, use refinancing to lower your monthly payments or shorten your loan term to save money in the long run.

    FAQs about how car loans work in Canada

    How do car loans work in Canada?

    Car loans in Canada are a form of financing where a lender provides the funds to purchase a vehicle and you repay the amount plus interest over a set period of time.

    What credit score is required for a car loan?

    Most lenders prefer a credit score of 650 or above for car loans, although some special lenders cater to those with lower scores.

    Can you sell a car with a loan on it?

    Yes, you can. However, if the loan is secured with the car, you must pay off the outstanding loan balance either before the sale or with the proceeds from the sale. The buyer will not be able to register the vehicle in their name until your lender releases their interest in the asset, which they won’t do until the balance is paid in full.

    Can debt consolidation help with car loans?

    Yes, debt consolidation can include car loans, potentially lowering your monthly payments and overall interest.

    Can I refinance a car loan?

    Absolutely. If your credit score has improved or interest rates have dropped, you may qualify for a better rate either with your existing lender or by switching to a new one.

    Can I pay off my car loan early?

    It depends on the lender and their policies. Traditional lenders, like banks and credit unions, typically let you pay off the loan early without any hassle or penalties. However, some private lenders may charge a prepayment penalty. Always check your loan terms and clarify the early payoff policy before getting a car loan, no matter who you borrow from.

    Are car loans fixed or variable interest?

    Car loans can have either fixed or variable rates, but fixed-rate loans are the most common type of car loan in Canada.

    What happens if I don’t pay my car loan in Canada?

    If you default on your car loan, it can severely damage your credit score, and the lender has the right to repossess the car.

    How to get approved for a car loan?

    Having a good credit score, stable employment income, and a down payment can increase your chances of approval.

    How to get out of a car loan in Canada?

    You can sell the car to pay off the loan, trade it in, or refinance the loan to lower the monthly payment.

    How to transfer a car loan to another person in Canada?

    Most lenders don’t allow direct transfers. However, the other person can get a new loan to buy the car, and you then use the proceeds to pay off your existing loan.

    Can you get a car loan with bad credit?

    Yes, but interest rates will likely be higher and the terms may be less favourable. There are private lenders who specialize in bad credit car loans.

    Which bank has the best car loan rates?

    It varies based on your situation and the market. It’s wise to shop around at various banks, credit unions, and private lenders. There are sites that allow you to compare loans from various lenders to find the best deal for your situation.

    Is it better to apply for a car loan jointly?

    Joint applications can increase your chances of approval if the co-applicant has a strong credit score and income. In most cases, the co-applicant is also the co-owner of the vehicle which gives them legal rights to the asset.

    Are car loan interest rates annual or monthly?

    Car loan interest rates are typically expressed as an annual percentage rate (APR), which is divided into monthly payments.

    Are car loans good for credit?

    Yes, depending on how you handle the loan. If payments are made consistently and on time, they can boost your credit score.

    Are car loans simple or compound interest?

    Car loans typically use simple interest, calculated only on the original amount of the loan. That means the interest is not added to the balance which then accrues more interest.

    Can a car loan be transferred to another person?

    Most lenders don’t allow this. The new person usually must secure their own financing to buy the vehicle from you, and the proceeds are used to pay off the existing loan.

    Can I buy a car with a personal loan?

    Yes, but unsecured personal loans often have higher interest rates than secured car loans.

    Can I get a car loan without a license?

    It’s possible, but uncommon. Lenders typically prefer borrowers to have a valid driver’s license.

    Can you get a car loan at 17?

    Not likely. In Canada, you generally must be at least 18 years old to enter into a legally binding loan contract.

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    Heidi Unrau is a senior finance journalist at Hardbacon. She studied Economics at the University of Winnipeg, where she fell in love with all-things-finance. At 25, she kicked-off her financial career in retail banking as a teller. She quickly progressed to become a Credit Analyst and then Private Lender. This hands-on industry experience uniquely positions her to provide expert insight on loans, credit scores, credit cards, debt, and banking services. She has been featured in publications such as WealthRocket, Scary Mommy, Credello, and Plooto. When she's not chasing after her two little boys, you'll find her hiding in the car listening to the Freakonomics podcast, or binge-watching financial crime documentaries with a bowl of ice cream. Fun Fact: Heidi has lived in five different provinces across Canada and her blood type is coffee.