November 2022
How they work and the pros and cons of each
Personal Loans vs. Car Loans: An Overview
If you’re in the market for a major purchase like a car, you may well need to take out a loan to cover the cost. Personal loans and car loans are two of the most common financing options. Assuming you meet their respective lending requirements, they can be relatively easy to obtain.
So what’s the difference between the two? A personal loan can be used for many different purposes, including buying a car, whereas a car loan (as the name implies) is strictly to purchase a vehicle. Each loan type bears its own pros and cons; it’s important to weigh and compare them before signing on the dotted line.
KEY TAKEAWAYS
- A personal loan can be used for many different purposes, whereas a car loan is strictly for the purpose of purchasing a vehicle.
- A personal loan can be secured against something of value, or more commonly, unsecured.
- A car loan is secured against the vehicle you intend to purchase, which means the vehicle serves as collateral for the loan.
- In either case, good credit typically means it's easier to get approved and to be offered better loan terms.
Personal Loan
A personal loan provides the borrower with funds from a lending institution (generally a bank), in a lump sum that the borrower can use at their discretion, such as for a vacation, wedding, or home improvement.
A personal loan can be secured against something of value, such as a vehicle or home, allowing the lender to seize your asset to recover its losses if you don't repay the loan. However, most people opt for an unsecured loan, which means the loan is made without collateral.
Two key elements that affect the total amount paid on a loan are the interest rate and the loan term. A personal loan calculator can be a useful tool for determining how these factors will affect what you'll pay for each month.
Interest Rates
Generally, unsecured loans have higher interest rates than comparable secured loans with collateral attached. Unsecured personal loans also come with much more stringent approval requirements, so you’ll want excellent credit on your side. If yours is in poor shape, a personal loan might not be an option.
Your credit score will influence both the loan amount and the interest rate, which can be fixed or variable. The better your credit score, the higher your borrowing capacity, and the lower your interest rate. Conversely, the poorer your credit rating, the lower your borrowing capacity and the higher the rate.
Pros
No restrictions on how funds are spent
Flexibility in payment structure (short versus long term)
Cons
Interest rates likely to be on the high side
Tougher lending requirements
Consumers with poor credit scores won’t qualify
The Terms
Personal loans have a set repayment period, stated in months—12, 24, 36, etc. Longer loan terms will lower your monthly repayment, but you’ll be paying more interest over the term of the loan. Conversely, shorter loan terms mean higher monthly repayments, but incur less interest overall, since you are paying off the principal faster.
Important: Most lenders accept online applications for personal loans and you can often get approved for a car loan on the spot at the car dealership.
Car Loan
A car loan is secured against the vehicle you intend to purchase, which means the vehicle serves as collateral for the loan. If you default on your repayments, the lender can seize the auto. The loan is paid off in fixed installments throughout the loan. Much like a mortgage, the lender retains ownership over the asset until you make the final payment.
In order to determine what interest rate and loan term would best suit your needs before you head to the dealership, consider experimenting with an auto loan calculator first.
Interest Rates
Given that the lender has financial control over the car—it's a secured loan—the debt is deemed a lower risk, which generally translates to a significantly reduced interest rate for the borrower. Interest rates are also fixed, so borrowers are not subjected to the increases that can be associated with unsecured personal loans.
Pros
Usually a lower interest rate
Easier to obtain with mediocre credit history
Often a convenient "on the spot" finance solution
You don’t have title to the car until the final repayment is made
An upfront deposit is generally required to secure the loan
The Terms
Most car loans are fixed at 36, 48, 60, or 72 months. And just like the personal loan, the shorter the term, the higher the monthly repayment and vice versa. A less-than-average credit history won’t necessarily stand between you and your car loan (unlike a personal loan). It will also have less impact on your interest rate or borrowing amount, which is dictated by the price of the car.
There are a variety of ways to get car loans. Before signing up for a dealer loan, it can be worth investigating whether a local bank or credit union can give you a better deal.
Special Considerations
Regardless of whether you choose a personal loan or a car loan, rates and deals vary between institutions. So do your homework and shop around for the best deal. Explore banks, credit unions, and other lending platforms to find the best combination of interest rates and loan lengths for an affordable monthly payment.
The Bottom Line
When it comes to buying a new car, many consumers will opt for a dealer-financed auto loan because it’s quick and convenient. But in some cases, it can be more effective to obtain a personal loan instead. To make an informed decision, start by asking yourself these questions:
- Do I have collateral with which to secure the loan?
- What interest rate (and associated repayments) can I genuinely afford?
- Is my credit in good enough shape?
Deciding between the two all comes down to weighing the pros and cons in light of your individual circumstances.
Source: investopedia.com
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