Should You Get a Car Loan or Personal Loan? A Detailed Comparison

Getting a new car is an exciting milestone in life. However the thrill of the purchase can quickly be dampened when it comes time to figure out how you will pay for the vehicle. Two common options are taking out a car loan or a personal loan. But which one is the better choice for financing your new wheels?

In this comprehensive guide, we will compare and contrast car loans versus personal loans to help you make an informed decision when buying your next car.

An Overview of Car Loans and Personal Loans

A car loan is a type of secured loan specifically used to finance the purchase of a new or used car. The vehicle serves as collateral for the loan, meaning the lender can repossess it if you default on payments.

Car loans are available at most banks, credit unions, and directly through car dealers. You’ll need a good credit score to qualify for the lowest interest rates on a car loan, which currently average around 5% for new cars and 8% for used cars.

Meanwhile, a personal loan is an unsecured loan that you can use for any purpose Common uses include consolidating debt, financing home improvements, paying medical bills, or making a major purchase like a car

Personal loans are offered by banks, credit unions, online lenders, and peer-to-peer lending marketplaces Interest rates are higher than car loans, averaging 10-28% depending on your credit score

Now let’s take a deeper look at the pros and cons of each option for financing a car purchase.

Key Differences Between Car Loans and Personal Loans

Interest Rates

The most notable difference between car loans and personal loans is the interest rate you will pay.

Car loans have lower average interest rates because they are secured debt. If you stop making payments, the lender can take back the car and sell it to recoup their losses. This makes them less risky for lenders.

Personal loans are unsecured, so there is no collateral for the lender to fall back on. To compensate for the higher risk, lenders charge higher interest rates on personal loans.

On average, interest rates on car loans range from 3-7% for new cars and 5-12% for used cars with applicants who have good to excellent credit scores.

Meanwhile, personal loan rates for borrowers with good credit tend to fall between 10-28%. So you’ll almost always pay a higher rate with a personal loan.

Loan Amount

Both car loans and personal loans can finance a car purchase of $5,000 to $100,000 or more. However, personal loans have more flexible limits.

A lender will only approve you for a car loan amount high enough to cover the purchase price of your vehicle, taxes, fees, and any extras like an extended warranty. So the loan amount is tied directly to your car transaction.

With a personal loan, you can borrow as much or as little as you need. This gives you flexibility to purchase a less expensive used car but borrow extra for insurance, registration, repairs, or accessories.

Loan Term

Car loans and personal loans generally have similar terms of 1-7 years. The longer the term, the lower your monthly payment will be.

However, you also pay more interest over the life of the loan with a longer term. It’s recommended to stick to a 3-5 year repayment term at most when financing a car to save on interest charges.

Some personal lenders may offer shorter or longer maximum terms than a car loan, giving you a bit more flexibility. But take the interest costs into consideration.

Prepayment Penalties

Most car loans and personal loans allow you to pay off your balance early with no prepayment penalty. This is important if you want the option to refinance your loan, trade in your car for a new one, or simply decide to pay off your loan faster.

However, some lenders may charge a fee for paying off a personal loan early. Always check the fine print first before choosing a personal loan for your car purchase.

Credit Requirements

Qualifying for a car loan or personal loan requires good to excellent credit, typically 690+ on your FICO credit score.

Lenders may have additional requirements around your debt-to-income ratio, income level, and employment history. Car loans and personal loans will look at all the same factors when evaluating your application.

If your credit score is fair (640-689) or poor (below 640), you may still qualify for a car loan from a specialty lender at a higher interest rate. Most personal loan lenders will not approve applicants with scores below 690.

Fees

When it comes to fees, car loans tend to be the more expensive option. You may have to pay an origination fee to the lender as well as an acquisition fee to the dealership. These can add a few hundred dollars to your loan amount.

Most personal loans do not charge origination or other fees. Instead, the costs are simply baked into the APR. This helps keep the loan process simple without a lot of surprise fees.

Collateral

With a car loan, the vehicle you are financing serves as collateral on the loan. This gives the lender the right to repossess your car if you default on the loan.

Personal loans are unsecured, so you don’t pledge any collateral. This means the lender cannot seize your vehicle or other assets if you fail to repay the loan. However, the lender can still take legal action against you and/or send the account to collections, damaging your credit.

If you have concerns about repossession but want the lower rate of a car loan, gap insurance can help. It covers the gap between what your vehicle is worth and what you still owe on your loan if it is totaled or stolen.

When a Car Loan Is the Better Choice

In most cases, a car loan will be the most affordable financing option for purchasing a vehicle. Here are some of the best situations for getting a car loan:

• You have good credit – Car loan rates drop significantly for those with credit scores above 700, making it very affordable. With excellent credit (750+ scores), rates can be as low as 3%.

• You’re buying a new car – New car loans tend to have lower interest rates than used because the vehicle has higher collateral value. Rates for used cars are usually 0.5-2% higher.

• You’re making a large down payment – Putting down 20% or more of the vehicle’s value reduces risk for the lender, often earning you a lower interest rate on a car loan.

• You can get pre-approved – Being pre-approved for a car loan locks in an interest rate for you. Rates offered directly by a lender are typically lower than those from dealers.

• You want lower monthly payments – Car loan terms up to 6 years allow you to lower your monthly payment, which may fit better into your budget.

As long as you qualify based on your credit, income, and existing debt obligations, a car loan is the most cost-effective way to finance the purchase of a new or used car.

When a Personal Loan is the Better Choice

Here are some situations when it may make sense to take out a personal loan instead of a car loan:

• You have fair credit – Lenders may deny a car loan application for those with scores below 660. But you may still qualify for a personal loan with less stringent requirements.

• You have limited income or high debt – Not meeting a lender’s standards for debt-to-income ratio or income level may make you ineligible for a car loan but not a personal loan.

• You’re buying from a private seller – Personal loans allow you to buy a used car from an individual seller, whereas car loans are only for dealer purchases.

• You need funds for extras – A personal loan provides funding upfront for taxes, fees, accessories, or repairs in addition to the vehicle purchase price.

• You want loan portability – You can take out a personal loan before you find the right car. The funds are available for months until you need them.

While a personal loan is more expensive, it’s an option if you don’t qualify for traditional auto financing. Be sure to shop rates from multiple lenders to find the most competitive APR based on your credit profile.

Tips for Financing a Car With a Personal Loan

If you’ve weighed the pros and cons and decided a personal loan is your best course of action for financing a car, here are some tips to make the process go smoothly:

• Check your credit – Request copies of your credit reports so you know exactly where you stand. Time it right before applying so you have the most up-to-date information.

• Compare loan offers – Applying with multiple lenders will allow you to compare interest rates and ensure you get the best deal. Avoid unnecessary hard inquiries on your credit by limiting applications to 2-3 lenders.

• Choose the shortest term possible – Opt for a 3 year repayment term over 5 years to pay less interest and own your car sooner. Make extra principal payments when you can.

• Look for the best prepayment policy – Having the option to pay off your loan early without penalty provides flexibility down the road.

• Understand the fine print – Read the loan agreement carefully so there are no surprises