What is a car title loan and how does it work?

When you're in a financial bind and need cash quickly, taking out a car title loan might seem like an easy fix. An auto title loan is a short-term, high-interest loan that uses your vehicle as collateral. And while it's highly accessible and easy to qualify for (if you own your car outright), you risk losing your ride if you fall behind in payments. Add in the eye-watering expensive terms and conditions that usually come with these loans, and you have plenty of reasons to look for alternatives before resorting to a car title loan.

Below, CNBC Select explains how title loans work, why you should think twice (or more) before taking one out and what you can do instead.

A car title loan allows you to borrow 25% to 50% of your vehicle's value. In return, you agree to pay off the entire loan balance plus interest when the loan term ends — typically, in 15 or 30 days.

To qualify, you'll have to give the lender your car title. Most lenders require that you fully own your vehicle, while others will lend you money if you meet certain equity thresholds. You'll also likely need to provide your photo ID and proof of insurance to the lender, as well as an extra set of keys.

You usually can get a title loan without a credit check or having your income verified (though some states require lenders to do both). This makes getting a title loan incredibly easy, but the terms put the borrower at a huge disadvantage. According to the Federal Trade Commission (FTC), car title lenders typically charge an average monthly finance fee of 25%, which translates to a 300% APR. You might also have to pay extra charges such as processing, document and loan origination fees. 

And these already-hefty costs will increase if you need more time to repay the loan. Similar to payday loans, car title loans may allow rollovers, meaning your original loan is renewed into a new one with added interest and fees.

If you fail to repay the money you owe, the lender has the right to repossess your vehicle. In some states, when the lender sells the vehicle, they're allowed to keep the money even if it's more than the amount you owe.

Most of the time, title loans don't affect your credit. If the lender doesn't run a credit check, there will be no hard inquiry on your credit report. By the same token, your on-time payments won't help your credit either since the lender won't report them to credit bureaus.

If you default on the loan, the lender won't need to sell your debt to a collection agency since they get to repossess and sell your vehicle. With the debt satisfied, they don't report the default.

Thanks to short terms and high costs, a title loan can easily pull you into a vicious cycle of debt. With a rollover being an option, you may find yourself renewing the loan over and over, piling on more debt to avoid losing your car. This is a common scenario — according to a survey by the Consumer Financial Protection Bureau (CFPB), in June 2019, 83% of consumers who'd taken out a car title loan in the previous six months still owed money on it.

Even if you find yourself in a dire financial situation, without an emergency fund and with a credit score that could use some work, consider an auto title loan the last resort and seek out other solutions.

When you're struggling with money, it may seem as though you don't have options if you need to come up with cash urgently. Luckily, that might not be true. Here's what you can look into instead of a car title loan:

• Credit cards. Most of the best credit cards for bad credit are secured, meaning they require you to deposit money as collateral. Still, you can find unsecured cards (like Credit One Bank® Platinum Visa® for Rebuilding Credit) that tend to be accessible to those with low credit scores. Such cards may come with higher interest rates and expensive fees — but those costs are peanuts compared to what a title loan will typically charge. And if you need cash, you can take out a cash advance from your card. A cash advance typically has a higher interest rate and offers no grace period, but if you pay it off quickly, it will still be much cheaper than a title loan.

• Personal loans. It's possible to get a personal loan with bad credit. Lenders such as Avant offer loans as small as $1,000 and can send you the funds the next business day after you complete all the paperwork. Again, interest rates and origination fees might be higher than those for borrowers with higher credit scores, yet low compared to car title loans. Plus, you'll get more time to repay the debt.

• Family or friends. Asking for help might be the last thing you want to do — and money conversations are rarely comfortable. But your loved ones may be only happy to offer a helping hand. That said, not repaying your friend or family member as agreed won't hurt your credit, but it may hurt your relationship. Be transparent and avoid making promises you can't keep.

A car title loan might appear as a quick and simple way to borrow some cash but later turn into an expensive debt trap. Avoid this dangerous lending practice and try to look for a different solution to your money crunch. And once you find yourself in the clear financially, work on revising your budget, paying down debt and improving your credit to prevent the same from happening again.

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