Car title loans: What they are and how they work

All loans come with risks if they’re not repaid on time. However, a car title loan carries an especially troubling consequence if you fail to meet your payment obligations: The lender can take your vehicle.

Before you consider getting a title loan, it’s vital to understand the potential drawbacks of using your vehicle as collateral to borrow money.

What are car title loans?

A car title loan, or “pink slip loan,” allows you to borrow anywhere from 25 percent to 50 percent of the value of your vehicle in exchange for giving the lender the title to your vehicle as collateral. These short-term loans typically start at $100 with repayment periods of 15 to 30 days.

Car title loans cater to consumers with past credit challenges who need fast cash. Most lenders have little to no credit requirements — some won’t even check your credit. The application process is usually simple, and if approved, you can expect to receive funding as soon as 24 hours later — sometimes even sooner.

The ease of access also means these loan products come with steep interest rates. Some states limit how much interest lenders can charge while others have no restrictions. And in some states, lenders are prohibited from offering car title loans to consumers.

If you live in a state where car title loans are allowed, you will generally need to own your car outright to obtain a loan. Some lenders provide these loans if your vehicle is nearly paid off, but this is less common.

How do title loans work?

Car title loans come in a couple of different varieties. Some are single-payment loans, meaning the borrower must pay the full amount of the loan plus the interest rate fee within a month or so. Installment loans can be paid back over three or six months, depending on the lender.

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While the term “car” may be in the product name, these loans also can be available for motorcycles, boats and recreational vehicles.

You can apply online or in person, but you’ll need to visit a physical location to show your car to the lender. Also, prepare to provide the lender with a clear title, proof of insurance and a photo ID when applying for a car title loan. The lender may also want a set of keys. The car will remain in your possession during the repayment period unless you default on the loan.

To illustrate how these loans work, assume you own a car worth $5,000, and you find yourself in an emergency and need $1,000. A title loan lets you borrow against your vehicle so you can get the $1,000 quickly.

Just as a mortgage uses your home as collateral, a title loan uses your vehicle as collateral. To get the title to your vehicle back, the loan must be paid in full, including the steep fees the lender charges for providing the money.

These fees typically include an average monthly finance fee of 25 percent, which translates to an APR of 300 percent. On a $1,000 loan, you’ll pay an additional $250 in interest even if the loan is repaid in just 30 days. If you’re late with your payment and late payment penalties are assessed, the loan could cost you a small fortune.

Some lenders also charge origination, processing and document fees, driving the borrowing costs up even higher. You may also be required to obtain and pay for a roadside service plan for your vehicle.

Downsides to title loans

While getting a title loan may be easy, the convenience comes with serious costs and risks, according to Graciela Aponte-Diaz, director of federal campaigns at the Center for Responsible Lending.

“If you can’t pay back the loan when it’s due, it’s rolled over into another cycle with more fees,” says Bruce McClary, senior vice president of communications at the National Foundation for Credit Counseling. “It creates a very difficult situation for people who are already struggling to repay. It is the exact definition of the cycle of debt.”

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The biggest downside, though, is the potential to lose your car. If you can’t repay the loan, the lender can take your vehicle and sell it to recoup their money. And this isn’t all that uncommon. A study from the Consumer Financial Protection Bureau found that 20 percent of those who take out title loans have their vehicles seized.

Even worse, “some car title lenders install a GPS device — nicknamed a ‘kill switch’ — that can prevent the borrower’s car from starting, using this practice as a means of collecting a debt or making it easier to seize the car,” Aponte-Diaz adds. Given the very real risk of losing your main means of transportation, it’s easy to see how a title loan can be a stressful experience.

Alternatives to title loans

With such serious downsides, McClary recommends reaching out to traditional banks and credit unions to identify less costly lending options. Or you can use a credit card if you have one available to meet your short-term cash needs.

Even if you don’t have a bank account, have a lower credit score or have struggled with poor financial decisions in the past, it’s worth investigating all your alternatives.

“It’s interesting how flexible these traditional lenders can be,” McClary says. “There are a lot of credit unions that are willing to work with unbanked customers.”

Apply for a personal loan

Although qualifying for a personal loan can be challenging if you have bad credit, you may have options. Some online lenders feature bad credit loans you could be eligible for.

If you’re a credit union member, you can also try explaining your situation to a banker. They may approve you for a loan based on the strength of your relationship and good banking history. Or you can ask a friend or relative with a steady source of income and strong credit rating to apply with you as a cosigner, strengthening your approval odds.

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Seek a payday alternative loan

Payday alternative loans are another less costly option to consider. They’re available through some credit unions, but you must be a member to access this loan product. Loan amounts range from $200 to $2,000, payable over one to 12 months.

The application fee is capped at $20, and you’ll pay no more than 28 percent in interest. This makes payday alternative loans more affordable than car title loans and some bad credit personal loans.

Use a credit card

You can also use a credit card if you have a dire financial emergency. Or you can pull funds from your credit card through a cash advance.

Be mindful that the interest rate for cash advances is usually higher than you’ll pay for purchases — up to 30 percent variable. Plus, there’s no grace period and interest will start accruing right away. Expect to pay an ATM fee to withdraw funds.

McClary rarely advises adding to credit card debt but says it’s a better option than a title loan, as you’re likely to pay far less in interest than you would with a car title loan.

The bottom line

Car title loans are a convenient option for getting fast cash. Still, the costs are usually not worth the risk involved, and you could end up in a far worse position than you were before taking out the loan. Consider more affordable alternatives, like a credit card, personal loan or payday alternative loan, before settling on a car title loan.

But if you’ve exhausted all your options and must use a car title loan, be sure to read the fine print. Title lenders must show you loan terms in writing before signing, and federal law requires that they be honest and upfront about the total cost of the loan.