Personal Loans vs. Car Loans: How They Differ
If you’re in the market for a major purchase like a new car, or need some extra cash to fund a personal project, taking out a loan could be your best bet.
Personal loans and car loans represent two of the most common financing options. Assuming you meet their respective lending requirements, they can be relatively easy to obtain. These days, most lenders accept online applications for personal loans, and car loans are generally approved on the spot at the car dealership.
So what’s the difference between the two? A personal loan can be used for many different purposes, whereas a car loan (as the name implies) is strictly for the purpose of purchasing a vehicle. If you want to borrow money for a car, you could simply take out a car loan, but if you require funding for a purpose that’s less specific or falls outside the typical lending box (such as a vacation, wedding or home improvement), a personal loan provides more flexibility.
Each loan type bears its own pros and cons, so it’s important to weigh and compare them before signing on the dotted line.
The Personal Loan (Unsecured)
A personal loan provides the borrower with funds from a lending institution (generally a bank), whereby the full loan amount is paid in a lump sum that can be used at the borrower’s discretion. Personal loan amounts typically range anywhere from $1,000 to $50,000.
A personal loan can be secured against something of value, such as a vehicle or home, allowing the lender can seize your asset to recover its losses in the event that you don't repay the loan. However, most people opt for an “unsecured” personal loan, which means the loan is free from collateral.
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 – that is, until you can strengthen it (see 3 Easy Ways To Improve Your Credit Score). Both the loan amount and the interest rate (which can be fixed or variable) will be largely influenced by your credit rating. The better your credit rating, 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.
Personal loans have a set repayment period, stated in months (e.g. 12, 34, 36). 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.
To sum up the unsecured personal loan:
- no restrictions on how funds are spent
- flexibility in payment structure (short vs. long term)
- interest rates likely to be on the high side
- tougher lending requirements apply
- consumers with poor credit scores won’t qualify (see How Bad Is My Credit Score?)
The Car Loan (Secured)
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 over the period of the loan. Much like a mortgage, the lender retains ownership over the asset until the final payment is made.
Given that the lender has financial control over the car – it's a “secured” loan – the debt is deemed lower risk, which generally translates to a significantly reduced interest rate for the borrower. Interests rates are also fixed, so borrowers are not subjected to the increases that can be associated with unsecured personal loans.
Most car loans are fixed at 36, 48 or 60 months. (See How Risky Are Long-Term Car Loans?) 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), and it will have less impact on your interest rate or borrowing amount (which is dictated by the price of the car). 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. Use this credit-union calculator to check the difference and read The Complete Guide To Buying A New Car: How To Finance A New Vehicle.
To sum up the secured car loan:
- 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 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. It all comes down to weighing up pros and cons against in light of your individual circumstances.
Ask 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?
Regardless of which loan direction you take, rates and deals vary between institutions, so do your homework and shop around for the best deal. Explore banks (big and local), credit unions and other lending platforms to find the best combination of interest rates and loan length for an affordable monthly payment.