Ready to buy a new car? Figuring out the financing can be just as important as picking the right model. Two common options you’ll encounter are auto loans and personal loans. While both provide the funds you need, they work in fundamentally different ways, and choosing the right one can save you a significant amount of money.
Many people assume an auto loan is the only way to finance a vehicle, but a personal loan can sometimes be a strategic choice. Understanding the mechanics, interest rates, and requirements of each will help you drive away with a deal that fits your financial situation, not just a new set of wheels. This guide breaks down everything you need to know about auto loans versus personal loans to help you make the smartest decision.
What is an Auto Loan?
An auto loan is a specific type of financing designed solely for purchasing a vehicle. It’s a secured loan, which means the car you’re buying acts as collateral.
How It Works
When you take out an auto loan, the lender places a lien on the vehicle’s title. This lien gives them a legal claim to the car until the loan is fully paid off. If you fail to make your payments (default on the loan), the lender has the right to repossess the vehicle to recover their losses. This secured nature is what makes auto loans a less risky proposition for lenders.
Pros of an Auto Loan
- Lower Interest Rates: Because the loan is secured by the car, lenders face less risk. They pass this security on to you in the form of lower interest rates compared to unsecured loans.
- Easier to Qualify For: The collateral makes it easier for borrowers, even those with less-than-perfect credit, to get approved. Lenders are more confident they can recoup their money if you default.
Cons of an Auto Loan
- Restricted Use: The funds from an auto loan can only be used to purchase a vehicle. You can’t borrow extra to cover insurance or immediate repairs.
- Risk of Repossession: The biggest drawback is the risk of losing your car if you can’t keep up with payments. This can be a major disruption to your life, affecting your ability to get to work or manage daily errands.
What is a Personal Loan?
A personal loan is a versatile financing option that provides you with a lump sum of money you can use for almost any purpose, including buying a car. Most personal loans are unsecured, meaning they don’t require any collateral.
How It Works
With an unsecured personal loan, approval is based solely on your creditworthiness—your credit score, income, and debt-to-income ratio. Since there’s no collateral for the lender to seize if you default, they take on more risk. To compensate for this increased risk, they typically charge higher interest rates.
Pros of a Personal Loan
- Flexible Use: You can use the money for anything you want. This means you could borrow enough to cover the car’s purchase price, plus title fees, taxes, and even a new set of tires.
- No Risk of Losing the Vehicle Directly: Because the loan is unsecured, the lender can’t simply repossess your car if you miss payments. However, defaulting will still have severe consequences, including significant damage to your credit score and potential legal action.
Cons of a Personal Loan
- Higher Interest Rates: The lack of collateral makes personal loans riskier for lenders, resulting in higher Annual Percentage Rates (APRs).
- Harder to Qualify For: Lenders rely heavily on your financial history. A strong credit score and a stable income are usually necessary for approval, especially for a loan large enough to buy a car.
Detailed Comparison: Auto Loan vs. Personal Loan
Let’s put them side-by-side to see how they stack up in key areas.
Interest Rates
This is where the biggest difference lies. Auto loans almost always have lower interest rates. For a borrower with a good credit score, an auto loan APR might be between 6-8%, while a personal loan APR could be anywhere from 10-20% or even higher. Over a 5-year loan term, that difference can add up to thousands of dollars in interest payments.
Loan Amounts
Auto loans are tied to the value of the car. Lenders will typically finance the car’s purchase price, and sometimes a little extra for taxes and fees. Personal loans, on the other hand, can range from $1,000 to $100,000, depending on the lender and your creditworthiness. This might give you more flexibility if you need a smaller loan for a cheap used car or a larger sum for a classic car that traditional lenders won’t finance.
Repayment Terms
Both loan types usually have fixed monthly payments over a set period. Auto loan terms typically range from 36 to 84 months (3 to 7 years). Personal loan terms are often shorter, usually between 24 and 60 months (2 to 5 years), though some lenders offer longer terms. A shorter term means higher monthly payments but less interest paid overall.
Credit Score Requirements
Because auto loans are secured, they are often more accessible to people with fair or poor credit (scores below 670). Personal loans are tougher to get with a low credit score, and if you are approved, the interest rate will likely be very high. For the best rates on either loan, a credit score above 720 is ideal.
Fees and Charges
Both loans can come with fees. Look out for:
- Origination Fees: A fee for processing the loan, more common with personal loans.
- Prepayment Penalties: A fee for paying off the loan early. This is less common now but still exists.
- Late Fees: All lenders charge fees for missed or late payments.
Which Loan is Right for Your Situation?
Your financial profile and the type of car you’re buying will determine the best choice.
- Scenario 1: Buying a New or Gently Used Car
If you have decent credit and are buying a newer car from a dealership, an auto loan is almost always the more cost-effective option due to the lower interest rates. - Scenario 2: Buying from a Private Seller or Buying a Classic Car
Sometimes, lenders have restrictions on the age or mileage of cars they’ll finance with an auto loan. If you’re buying an older car from a private seller, a personal loan might be your only option. It gives you the cash to make the purchase without lender restrictions on the vehicle. - Scenario 3: You Have Excellent Credit
If your credit score is exceptional (800+), you might qualify for a personal loan with a competitive interest rate. It’s worth comparing quotes for both to see which offers the better deal. The flexibility of a personal loan could be appealing if the rates are close. - Scenario 4: You Have Poor Credit
If your credit is shaky, getting approved for an unsecured personal loan will be difficult. A secured auto loan is likely your best bet, as the collateral makes you a less risky borrower.
Final Recommendations
For most people buying a car, an auto loan is the clear winner for saving money. The lower interest rates secured by the vehicle itself will result in a lower total cost over the life of the loan. The straightforward nature of this financing makes it the standard for a reason.
However, a personal loan can be a valuable tool in specific situations. If you’re buying an older vehicle, purchasing from a private party who won’t work with a lender, or if you need to finance more than just the car’s sticker price, a personal loan provides the flexibility you need.
Before making a decision, get pre-approved for both types of loans from multiple lenders, including your bank, credit unions, and online lenders. Compare the APRs, terms, and fees to see which loan truly offers you the best deal for your circumstances.