Americans are borrowing more money to buy cars than ever before. Overall, auto debt in the U.S. grew by $80 billion in 2020, putting the total at $1.37 trillion.
When it comes to financing that new or used vehicle, you have options. Car dealerships usually offer car loans. You could also arrange a car loan through your financial institution. Or you could opt for a personal loan. You can use personal loans for many different purposes, including to pay for the car you’re buying.
When buying a car, the question of which is better, personal loans vs car loans, often comes up. Knowing the differences, as well as the pros and cons of each, can help you decide which is the best option for you.
Personal Loans vs Car Loans: the Difference
Banks, credit unions, and some online lenders offer both personal loans and car loans. Car dealerships usually offer car loans, especially for new or late-model used cars.
One of the primary differences between personal loans and car loans is that one type is a secured loan, and the other is not secured. When you get a secured loan, you put up an asset as collateral for the loan—a guarantee that you’ll pay back the money you borrowed.
Car loans use the car you are buying as collateral to secure the loan. So, if you don’t make your car payments, your loan agreement will allow the lender to repossess your car.
Personal loans are not secured. There’s no collateral to guarantee you will pay it off. That doesn’t mean a lender won’t pursue other means of payment should you default. They can still take you to court seeking payment. But they can’t automatically take your car.
You can use either loan type to buy a car. So, you’ll have to weigh the pros and cons of each to decide between personal loans vs car loans for your financial needs.
Pros:
1. Personal loans are flexible. Unlike car loans, you can use personal loans in any way you want. There are no restrictions as to how you spend the money. You can use the money to buy a car, pay tax and licensing expenses, take a vacation, pay off other debts, or anything else your heart desires.
2. Personal loans don’t require a downpayment. Since you can use personals loans for any purpose, it makes sense that there is no downpayment required, even if you plan to use the loan to buy a car.
3. Personal loans are unsecured. Borrowing money using personal loans doesn’t put anything you own at immediate risk. You haven’t promised anything as collateral for the loan.
For instance, if you buy a car with a personal loan and default on that loan, your lender can’t seize the car automatically. Instead, they would need to sue you, and a judge would have to order you to forfeit the car before they could take it.
4. Personal loans generally have a shorter, simpler application process. Since there is no collateral with a personal loan, all the lender needs to collect is personal information about you, like your income amount and where you work.
Cons:
1. Personal loans can have higher interest rates. Interest rates and fees can make a big difference in how much you pay to your lender over the life of your loan. The average interest rate in 2020 on a 24-month personal loan was 9.51%, almost double the interest rate of a new car loan that year.
Your creditworthiness determines your eligibility for a personal loan. Lenders look at your credit score and credit history in deciding whether or not to lend you money. They also consider your debt-to-income ratio, which is your current income compared to your current amount of debt.
Because personal loans are unsecured, lenders take a bigger risk in approving one. So, interest rates for personal loans can vary greatly. It’s a good idea to get a personal loan comparison before taking out a loan. That way, you can get the best terms for the loan you need.
2. Personal loans usually require you to have good credit. Because they are based solely on your ability and likelihood to pay the loan back, personal loans aren’t generally available for people with fair to poor credit.
Likewise, it’s difficult to get a personal loan if your income is too low compared to the amount of debt you already have, even if you have a history of paying your bills on time.
3. You may not be able to borrow as much as you want. Since personal loans are tied to your credit history, the amount of money available to you is affected by your credit score. A lower score often results in a lower loan amount.
4. Personal loans sometimes require you to pay additional costs. Those could be loan origination fees. The lender collects this additional amount and usually adds it to the total loan amount, making your payments higher.
5. Personal loans often have pre-payment penalties. That means if you pay the loan off early, you will pay a penalty. This helps offset the amount of interest the lender had expected to collect over the remaining life of the loan.
Pros and Cons of Car Loans
Pros:
1. Car loans often have lower interest rates than personal loans. For borrowers with excellent credit who are financing a new car through the dealership, interest rates can be as low as 0.0 APY, which is essentially no interest at all. Even borrowers with less than stellar credit can generally get a better rate on a car loan than on a personal loan.
2. Car loans are also available to people with poor credit. It’s easier to qualify for a car loan because there isn’t as much risk for the lender. That’s because a car loan is secured with collateral. Since the lender can repossess your car if you don’t pay, they are not risking as much as they would be if there were no collateral.
Some car dealerships specialize in financing car loans for people with poor credit.
3. A car loan will be for the full price of the car. You never have to worry about whether or not a car loan will be enough to pay for the car you are buying. Your car loan will cover the cost of the car you are buying minus any down payment you make.
4. Car loans usually have no additional loan fees. The amount financed is generally the amount required to drive the car off the lot. The lender makes their profit solely from the interest you pay on the loan. That means car loans are sometimes the more affordable option.
5. Car loans are less likely to have pre-payment penalties. If you decide to pay off your car early, you can pay only the remaining balance due on the day you make the payment.
Cons:
1. Car loans must be used to buy a car. Generally, they must be used to buy a specific car. That’s because the lender takes the details about the car into account when deciding how you can borrow.
2. Car loans won’t cover after-market improvements. You can use a car loan to pay for add-ons like custom wheels or a nice sound system. In some places, the tax, title, and licensing costs can be included in the car loan, but they cannot in other places.
3. Car loans often require a down payment. Lenders often require a down payment because it lowers the amount they will be financing. They are risking less, but the car’s value remains the same, so the collateral it represents is more valuable. As a trade-off, lenders will often give you a lower interest rate on your car loan if you make a down payment.
4. Car loans carry a heavy penalty for default. If you default on the loan, the lender can take your car. If you have financial trouble from and illness or job loss, losing your car can make matters worse. But with a secured loan, you agree to offer collateral as compensation should you default. Your car is the collateral for a car loan.
5. Car loans often take longer for the application process. Part of the reason is that the lender needs all of the details about the car you are buying since the car is being used as collateral.
Deciding Which Loan Type Is Right for You
No matter which type of loan you decide to use, the loan terms will largely depend on your credit score. With car loans, the type, age, and condition of the car you’re buying and any down payment you make will also affect the terms.
When weighing the question of which is better, personal loans vs car loans, the deciding factors should be based on your plans for the money and your financial goals.
