Personal Loan vs. Auto Loan: What’s the Difference?
When financing a car with a loan, it’s critical to assess your repayment capacity, vehicle goals, individual needs, and lender options. Weigh the pros and cons of personal loans and auto loans to determine which financing strategy better suits your needs.
If you aren’t sure about what loan to obtain, it’s advisable to shop around, compare lenders, and consult a financial advisor for expert guidance before making the final borrowing decision.
Personal loans and auto loans are two popular, viable options to finance a vehicle. Personal loans are versatile but potentially more expensive. Auto loans are tailored to financing specific vehicles but require collateral.
Understanding the key characteristics of each loan type can help you make an informed financial decision. In this guide, we’ll go over the main pros and cons of both personal and auto loans.
Definition and basics of each loan type
A personal loan is an unsecured loan that usually has a fixed interest rate and loan term. The rates and requirements mainly depend on your creditworthiness, which is evaluated by personal loan lenders after you apply for a loan. Personal loans can be used for nearly any purpose, including buying a car.
An auto loan is a secured loan designed specifically for purchasing a vehicle. The loan is secured by the vehicle itself, which acts as collateral. Auto loans usually come with fixed interest rates and terms.
While auto loans may offer lower rates than personal loans, it’s important to consider the collateral requirement and vehicle type restrictions.
Personal loan: Personal loan funds can be used for a wide variety of purposes. You can buy the vehicle and use the remaining loan funds for other needs, whether they are related to the vehicle or not.
Auto loan: An auto loan is vehicle-specific. You can usually only use the funds for buying the vehicle type that has been approved by the auto loan provider.
Collateral is required by loan providers to secure loans and reduce the risk on the lender’s part. While offering collateral can make it easier to obtain a personal loan with favorable rates and terms, it does mean you could lose those valuable assets in case of a loan default.
Personal loan: Most personal loans are unsecured, which means that they do not require any collateral as backing. Even if you do end up defaulting on the loan or missing payments, the lender cannot repossess your personal assets. Your vehicle will not be at risk if you take out an unsecured personal loan for a car.
Auto loan: Auto loans are typically backed by the vehicle you’re trying to buy. That vehicle becomes the collateral asset. If you default on the loan, the collateral will be repossessed by the lender in order to recoup losses. This is a serious risk associated with secured loans. If you’re financing a car with an auto loan, make sure you’re aware of the potential to lose your vehicle if you can’t repay the loan completely and on time.
The interest rate directly affects your cost of borrowing. Every time you pay a loan installment according to your repayment schedule, you are typically expected to pay a portion of the principal balance plus interest. A low interest rate usually helps you save more money.
Personal loan: Due to the lack of collateral of a personal loan, the interest rates could be higher. Personal loan interest rates vary between 6 and 36 percent mainly based on your creditworthiness and financial standing. However, if you have good to excellent credit scores, it might be cheaper overall to obtain a personal loan than an auto loan. The better your credit score, the more competitive interest rates you can obtain.
Auto loan: The collateral of auto loans makes the typical loan have lower interest rates. The average auto loan interest rate ranges between 5 and 28 percent.
The loan term is also referred to as the loan tenure or loan duration. It tells you how long the loan lasts, assuming you repay it by the loan maturity date (final day of loan repayment) without late payments.
In general, a longer loan tenure means you will need to pay more in interest. However, it also makes each installment cheaper and gives you more time to gather funds for paying off the debt. Make sure you choose a loan term that aligns best with your individual circumstances and repayment capacity.
Personal loan: A personal loan term can range from a few months to seven years depending on what you negotiate with your lender. If you want a particularly long or short loan tenure, you might need to pay more due to the atypical repayment schedule.
Auto loan: An auto loan typically ranges from two to five years. If you would prefer a longer term, you can negotiate different terms with the auto loan provider. A longer tenure may reduce the debt burden placed on you by reducing how much you need to pay each month. However, a shorter tenure means you can pay off the auto loan sooner.
Personal loan: Personal loans are relatively faster in terms of application processing and fund disbursement. You can even find same-day approval loans for the fastest funding in case you urgently need funds for a vehicle or other purpose.
Auto loan: The average auto loan can take weeks before you receive the funds. The vehicle-specific restrictions and loan terms may mean a longer period of underwriting and application processing.
Advantages of each loan
Each loan has its own advantages that can potentially help you meet your vehicle goals and needs. Here are some key advantages of each type of loan that you should know in order to make an informed financial decision.
Flexible fund usage: Personal loans are well known for their flexibility. You can use the loan funds for a wide range of purposes, including paying for cars, home improvement, medical expenses, debt consolidation, and more. In the case of buying a car, this means you can use any extra loan funds for vehicle-related expenses. Examples include car insurance, maintenance and repairs, as well as optional upgrades to enhance your sleek new ride.
No vehicle restrictions: Auto loans might restrict the type of car you can buy based on vehicle type or age. Fortunately, personal loans won’t come with these restrictions. You will be able to finance the car you want without vehicle type, age, or other limitations.
No down payment: There is usually no mandatory down payment when you’re using a personal loan to buy a new or used car. This can help reduce the immediate cost of purchasing a car, allowing you to obtain your dream vehicle without a heavy upfront charge.
Potentially lower interest rates: Auto loans have collateral, which makes them less risky for lenders to give to borrowers. This means that you can potentially enjoy lower interest rates and costs of borrowing.
Terms tailored to auto purchasing: Auto loans can be a convenient and cost-efficient financing method if you have a specific car model you want to secure in mind. The specific terms in the auto loan agreement may be able to help you obtain better deals and more favorable interest rates.
Promotional rates: Many dealerships offer promotional rates that are impressively low. Make sure you read the fine print if you opt for a promotional financing deal so that you aren’t caught off guard by any requirements or changes in costs.
Disadvantages of each loan
Higher interest rates on average: Without collateral to secure a personal loan, you are more likely to receive higher interest rates in loan offers.
Lower borrowing limits: If you have average creditworthiness, you might not be able to secure high loan amounts. Personal loan providers usually only offer their $100,000 maximum loan amount to those with excellent credit. Borrowers with poor credit may find it challenging to be approved for a loan with an amount suitable for a new vehicle.
Potential loan misuse: For some borrowers, the loan fund flexibility may actually backfire, resulting in irresponsible fund usage and unnecessary debt burdens. Being able to use the loan funds for almost any purpose you want can lead borrowers to spend the money lavishly on non-essentials.
Credit impact: If you default on a personal loan or miss loan payments regularly, you can hurt your credit score significantly. With any loan, it’s important to manage the debt repayment and interest accumulation responsibly.
Risk of vehicle repossession: Since you’re offering your vehicle as collateral, if you fail to repay the auto loan, that collateral vehicle can be seized by the lender. This not only causes you to lose your beloved new vehicle, but can also cause serious credit score damage.
Vehicle restrictions: Auto loan providers may put limitations on what vehicles you can use the loan funds to finance. Vehicle type and age are common restrictions.
Only covers vehicle price: Typically, when you take out an auto loan, the funds are only meant to cover the price of the vehicle itself. This means that you likely cannot use the loan funds for associated expenses, such as auto insurance and vehicle upgrades.
Credit impact: An auto loan can result in credit score damage if you don’t make the loan payments consistently and on time.
When to choose a personal loan for a vehicle
For buying older cars
If you want an older vehicle, a personal loan could be the best option. You might not be able to use auto loans for certain older vehicles.
Flexible fund usage
A personal loan allows you to freely choose what to do with the remaining funds after buying the vehicle itself. There are relatively few exceptions restricting the use of personal loan funds. For example, a personal loan can help you pay for:
- Auto insurance
- Car upgrades and accessories
- Other unrelated purchases
If you want to pay off the loan early
Most states allow auto loan providers to charge prepayment penalties, which means that paying an auto loan off early often results in extra fees. If you want to avoid prepayment penalties, you can opt for a personal loan that doesn’t come with any prepayment penalty. Make sure you read the fine print of the loan agreement carefully to confirm you can pay the debt off early without additional charges.
When to choose an auto loan
For buying new or certified used cars
Auto loans can be a solid way to finance new cars. Many dealerships offer promotional deals and incentives to those who buy their newer vehicles, which can make auto loans the more attractive financing strategy.
Lower interest rates
Auto loan interest rates usually range from 5 to 28 percent. Compared to the 6 to 36 percent interest rates of personal loans, an auto loan has lower rates on average.
If you don’t care about offering your car as collateral and are confident you’ll pay back the loan, it might be advantageous to take out an auto loan. If you have poor credit, personal loans can be expensive with their higher interest rates. However, opting for an auto loan with vehicle collateral can reduce your loan interest rate, allowing you to save money in the long run on interest.
Factors to consider before deciding
Your current and future expected financial health will affect your repayment capacity. Here are some of the main factors that affect financial stability and health:
- Existing debt obligations
- Credit score
Whether you want a new, used, or classic car can affect the optimal method of financing. Auto loans often place restrictions upon what cars you are allowed to use the loan funds to buy.
An essential step to take before deciding on a financing strategy is to consider the full expenses of buying your vehicle. Keep in mind the auto insurance premium, taxes, and any vehicle upgrades you might want to purchase.
Desired loan terms
Different preferred loan terms can significantly influence the overall borrowing cost of a loan. Make sure you think about the ideal length of repayment and interest rate for your particular situation.
With an auto loan, you might need to make a down payment when making the purchase. This can increase the upfront cost of a car, which may deter you from obtaining your dream vehicle.
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