Car Title Loan: What It is, How It Works, Example

What Is a Car Title Loan?

A car title loan is a type of short-term personal loan in which the borrower pledges their car as collateral. They are also known as auto title loans. In order to obtain a car title loan, the borrower must own their car free and clear. If the borrower fails to repay the loan, the lender takes ownership of the car and can sell it to recover their principal.

Understanding Car Title Loans

Car title loans are generally viewed as an example of subprime lending. This is because the loans are typically made to borrowers with lower incomes or relatively poor credit ratings, who are often unable to obtain other forms of financing, such as a personal line of credit (LOC). Because of the higher risk of default, car title loans generally carry high interest rates.

Critics argue that car title loans are a form of predatory lending because lenders are exploiting desperate borrowers who lack clear alternatives. Defenders of the practice argue that car title lenders are entitled to higher interest rates and collateral due to the higher-than-average default risk associated with subprime loans.

One controversial practice associated with car title loans—and short-term loans in general—is the use of non-annualized interest rates. For example, if a lender advertises a 30-day loan with a 10% interest rate without specifying whether the interest rate is annualized, the borrower might be fooled into accepting an extremely expensive loan. In some cases, these mistakes could cause the borrower to lose the title to their car due to underestimating the interest costs when budgeting for the loan's repayment.

Car title loans are generally made for relatively small sums, between a few hundred and a few thousand dollars. The exact balance is calculated based on the market value of the car pledged as collateral, with the loan amount often ranging between 25% and 50% of the car's value.

Applications for car title loans may be completed online or at a storefront. In either case, the applicant will need to present proof of their title to the car, their car insurance, their driver's license, and, of course, the car itself. Depending on the lender, the borrower may also need to install a GPS tracker on the car, in addition to a device that disables the car's ignition, should it become necessary to repossess the vehicle.

Real-World Example of a Car Title Loan

Taylor recently lost their job, and they are struggling to find the means to afford their upcoming rent payment. As a short-term solution, they decide to borrow money using a car title loan against their car, which has a current market value of $2,500. The loan provider agrees to extend a car title loan for $1,250.

In the application process, Taylor was required to provide proof of title to the car as well as additional documentation. The interest rate was advertised as 20% for the one-month duration of the loan, but Taylor made the mistake of assuming the interest rate was annualized. The true annualized interest rate was actually 240%—far more than Taylor would have accepted knowingly.

By the end of the one-month term, Taylor was required to repay $1,500, significantly more than the roughly $1,270 they were expecting. Given their desperate financial situation, Taylor was unable to find the additional $230 and was, therefore, forced to forfeit the title to their car.

The Bottom Line

Car title loans can be predatory lending tools that trap borrowers in high-interest cycles. Before using your car as collateral, carefully consider the annualized interest rate and any additional fees in order to understand the full picture of the cost of a car title loan.