April 6, 2021

Personal Loan Vs Auto Loan: How Should You Finance Your Car?

Lindsay VanSomeren READ TIME: 4 MIN.

New cars aren't cheap, and unless you have a pile of cash sitting around, you'll probably need to finance your vehicle. People who bought cars at the end of 2020 borrowed an average of $35,228 for a new car and $22,467 for a used car, according to a recent report from Experian, one of the three main credit reporting agencies.

With so much money on the line, you might be wondering what kind of loan is best for you: A car loan or a personal loan? While you can use either type of loan to finance a car, one may be a better choice than the other for your situation. We'll walk you through everything you need to know to make the right decision.

Key Differences: Personal Loan vs. Auto Loan

What Is a Personal Loan?

A personal loan is a type of unsecured loan that has a wide range of uses. Many people take out personal loans to consolidate debt at a lower interest rate, pay for house repairs or upgrades or cover car repairs. You can use personal loans for almost any type of expense, including financing a new car.

Personal loans generally come with higher interest rates than auto loans because personal loans are unsecured vs. secured.

While you typically don't need to make a down payment, your lender may charge an origination fee. If it does, you can often have the lender take it out of the loan proceeds, so you'll need to calculate how much extra to borrow to cover this fee. For example, if you're borrowing $12,000 with a $500 origination fee, you'll get $11,500.

Personal Loan Qualification Requirements

Lenders look at several factors when you apply for a personal loan, and each one sets their own specific qualification requirements. In general, you'll usually need a good credit score (670 or above) to qualify. Lenders will also look at your income to make sure you can afford the loan payments. If you're self-employed, you may need to provide two years' worth of tax returns to prove that you have a consistent earnings history.

What Is an Auto Loan?

An auto loan, on the other hand, is a secured loan that uses your car as collateral. This means that if you fall behind on payments or default on the loan, the lender can repossess your car to recoup its losses.

Since the lender is guaranteed to get paid one way or another, it's less risky for them to loan you the money. And because it's less risky, they pass those savings on to you in the form of a lower interest rate, which can save you a lot of money over the life of your loan.

Auto Loan Qualification Requirements

Just like with personal loans, each auto loan lender has its own qualification requirements. Since auto loans are secured, they can often be easier to qualify for, especially if your credit isn't the greatest. While we recommend a score of at least 670 to receive the most favorable terms, you may be able to qualify for an auto loan with a lower score, depending on your debt-to-income (DTI) ratio and down payment amount.

What's more, getting an auto loan can be trickier in some ways because most lenders are only willing to lend on certain model years or types of vehicles. For example, if you're financing an old car or a fixer-upper, it might be challenging to find an auto loan. However, if you're looking for a new, everyday commuting car, chances are a lender will lend you the money for a car you choose that you can afford.

Pros & Cons of Using a Personal Loan vs. Auto Loan

Pros of Financing a Car With a Personal Loan

  • No down payment: The biggest reason to choose a personal loan to pay for a car is that you don't need a down payment.
  • Less risk of repossession: If you default on the loan, your lender won't repossess your car (not right away at least – they can still pursue you in court).
  • Less restrictive: You can use a personal loan to buy any car you want as long as you can afford the loan for it.

    Con of Buying a Car With a Personal Loan

    Much more expensive: Personal loans carry higher interest rates than auto loans. According to the latest average rates from the Federal Reserve, two-year personal loans are almost twice as expensive as four-year auto loans (9.65% vs. 4.95% annual percentage rate (APR)).

    Pros of Buying a Car With an Auto Loan

  • More affordable: Auto loans are simply cheaper. If you took out a five-year, $25,000 loan using the interest rate from above, you'd pay $56 less per month with an auto loan, and you'd save $3,340 in interest by the time you paid off the car.
  • Easier to get: You generally don't need to have as good of a credit score to get an auto loan, although it certainly does help.

    Cons of Buying a Car With an Auto Loan

  • May not be able to borrow for all cars: Lenders have cutoff points for how old a car can be in order to finance it. It also generally has to be in working condition. An auto loan may not work if you want to restore an older classic car.
  • Need a down payment: Most lenders will require some sort of down payment. If you don't have a down payment saved, it can be tough to get approved for an auto loan.
  • The lender can repossess your car: You can lose your car very quickly if you fall behind on payments or default on the loan.

    by Lindsay VanSomeren

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