Banking and Finance

Auto Loans vs. Personal Loans: The Best Way to Finance Your Car

July 27, 2021

With inflation causing the cost of living to increase, it comes as no surprise that the cost of a new car has risen drastically as well. In 2021, Kelley Blue Book reported that the average cost of a new car had gone up over $6,200!

When facing the idea of having to shell out that much cash for a car, you’re probably wondering what type of loan is better when it comes time to finance a car. On one hand, auto loans are used specifically to finance cars. Personal loans, however, can be used for just about anything (yes, including purchasing a car).

Here's a breakdown of the pros and cons of each option to help you make the best decision for your needs.

What is Financing a Car?

Financing a car meaning the process of paying for a car over time with a loan. When you finance a car, the lender gives you the money to pay for the car, and you make payments back to the lender over time. 

What’s in it for the loan lender? The interest rate on your loan is how the lender makes money from lending you the money to buy the car. The higher your interest rate, the more money the lender will make from your loan. 

You can usually get a lower interest rate if you have a good credit score. This is really where the big difference between auto loans and personal loans comes into play. However, we’ll get to that in a bit!

What is an Auto Loan?

Auto loans are a type of financing used specifically to purchase a vehicle. Many people choose to finance their vehicles because it allows them to make smaller monthly payments over a longer period of time. Auto loans are available through a variety of lenders, including banks, credit unions, and online lenders.

How does auto loan work? Is an auto loan secured or unsecured? Well, auto loans are a type of secured loan that uses your car as collateral. This means that if you ever fall behind on your payments or default on the loan, the lender can take your car to recoup their losses.

However, since the lender is guaranteed to receive the money one way or another, there is less risk for him to lend the money, and because of the lower risk factor, the money can be disbursed at a lower interest rate. Ultimately, this is what makes an auto loan better in most cases for financing a car.

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What is a Personal Loan?

A personal loan is a type of unsecured loan, which means that it is not backed by any collateral. Personal loans are typically used for expenses like debt consolidation, medical bills, home improvement projects, major life events like weddings or vacations, and covering car repairs.

Can you use a personal loan to buy a car? The answer is, yes! Since you’re technically able to use a personal loan for pretty much anything at your discretion, it means you can use one to finance a new or used car. Just keep in mind that the interest rate on a personal loan is usually higher than on auto loans due to the lack of collateral backing.

Auto Loan vs. Personal Loan: The Differences

Okay, now that you know a bit about each type of loan, let’s explore some of the differences. The biggest difference is that one loan is secured by collateral (the car you’ve just purchased) and the other isn’t really secured at all.

This, in turn, leads to the second biggest difference. That is that a secured loan usually has much lower interest rates since the lender is guaranteed to get their money back in the event of a default. So, in general, auto loans come with much lower interest rates than personal loans.

The current average auto loan interest rate is about 3.86% for new cars and 8.21% for used cars. Even if you have excellent credit, the lowest interest rate you can expect to get on a personal loan is about 10%. That goes all the way up to 17-20% if your credit score is lower than 700.

In this context, it’s important to remember that the exact interest rate you get on a loan depends on your credit score (and the lender you choose). However, regardless of your credit score, a personal loan is going to end up being more costly in the long run.

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The Pros & Cons of Using an Auto Loan to Finance a Car

The most common way to finance a car is through a car loan which makes the most sense. Why? Well, for the reasons laid out above! Basically, an auto loan comes with lower interest rates than a personal loan.

However, the biggest drawback of using an auto loan to finance a car is that, if you fall behind on payments, there's a chance the lender will keep your car. Click here to learn more about repossession if you’ve never heard of what that entails.

The Pros & Cons of Using a Personal Loan to Finance a Car

In most cases, an auto loan tends to offer more advantages for car buyers, but a personal loan can make sense in certain situations.

For example, if you want to buy a collector’s car or a classic car, a personal loan might actually be the only option. In these special cases, not all auto lenders are willing to finance those types of vehicles.

In fact, a large number of auto loan lenders have restrictions on eligible vehicles. Cars must typically be less than 10 years old and have less than 120,000 miles.

Likewise, if your credit isn’t good enough to qualify for an auto loan but is good enough to qualify for a credit builder loan or a bad credit loan then that might be your only option. 

In this case, it’s going to make more sense to take out a bad credit loan so you can at least purchase your car and start building capital. Hopefully, you’ll also be making on-time payments regularly as you pay the loan back so that you can boost your credit score as you pay off the loan!

Auto Loan vs. Personal Loan: Which is Best?

Purchasing a car is a big investment. So, take your time when it comes to looking for the best financing option. An auto loan is a great option for those with good credit. However, if you have less than great credit and aren’t able to access an auto loan, using a personal loan to finance a car might be the only option.

If that’s the case, then we suggest working towards improving your credit score before you apply for any type of loan. This will ensure that you’re able to get the best interest rates possible, which will ultimately reduce the amount of money you have to pay during the entire life of your loan.

Need help building your credit score? Cheese is working hard to bring you a new credit-builder product. Stay tuned for easy and safe ways to improve your credit!