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When it comes to financing a car purchase you’ll typically come across two main types of loans secured and unsecured. Understanding the difference between secured and unsecured car loans can help you make an informed decision when buying a new or used vehicle.
Secured Car Loans Are the Norm
A secured car loan means the vehicle itself serves as collateral for the loan If you stop making payments, the lender can repossess your car and sell it to recoup their losses This gives lenders more security, allowing them to offer lower interest rates since the car acts as protection if you default.
Over 90% of car loans are secured loans because it benefits both the lender and the borrower. Lenders reduce their risk and consumers get better rates. Repossession is a last resort for lenders and something they want to avoid. As long as you make payments on time, you get to keep driving your car.
Unsecured Car Loans Are Riskier
An unsecured car loan does not use the vehicle as collateral. Instead, it’s essentially a personal loan used specifically for a car purchase. Since your car isn’t on the line, lenders take on more risk which results in higher interest rates, shorter loan terms, and stricter credit requirements.
If you default on an unsecured auto loan, the lender cannot legally seize your car. However, they can damage your credit by reporting the missed payments and take you to court to try and recoup the unpaid balance.
Unsecured loans give you flexibility since your car isn’t tied to the loan. But most people looking to finance a car are better off with a secured loan if they qualify.
Qualifying for an Unsecured Car Loan
Here are some common requirements for approval on an unsecured auto loan:
- Excellent credit – Typically a score of 720 or higher
- Low debt-to-income ratio – Lenders want to see you can afford the payments
- Strong income and assets – This helps offset the higher risk for lenders
- Clean credit history – Few or no late payments in your credit reports
Meeting these standards makes you less of a risk in the lender’s eyes. But you’ll still likely pay a higher interest rate than with a secured car loan.
Unsecured Loan Limits and Interest Rates
Many lenders cap their unsecured auto loans in the $20,000 to $40,000 range. Lightstream, for example, offers up to $100,000 but you’ll need pristine credit to qualify for that amount.
Interest rates on unsecured car loans typically start around 8% or higher for borrowers with great credit. In contrast, secured loan rates can be below 3% for those with excellent scores.
Always shop around and compare offers from multiple lenders when seeking an unsecured auto loan. Banks and credit unions you already use are a good place to start.
When an Unsecured Car Loan Makes Sense
Very few people will qualify for a six-figure unsecured auto loan. But some scenarios where a smaller unsecured loan could be useful include:
- Buying a classic or antique car that traditional lenders won’t finance
- Wanting flexibility to change your mind on the car or dealer at the last minute
- Owning the car free and clear with no lien holder
- Purchasing a used car from a private individual
- Maintaining insurance discounts by not having a car loan
For most buyers though, a secured car loan is the more practical and affordable financing option. As long as you make the payments, you get to keep the car with no hassle.
Pros and Cons of Unsecured Car Loans
Pros
- Easier process as a cash buyer
- Flexibility to change your mind on the car purchase
- No lien holder on the title if you own the car outright
Cons
- Higher interest rates than secured loans
- Shorter repayment terms making monthly payments larger
- Difficult to qualify based on credit requirements
- Lender can sue you for unpaid balance but cannot repossess vehicle
What Happens if You Stop Making Payments?
With a secured auto loan, the lender can legally repossess your car if you default. They will typically sell it and apply the proceeds towards your unpaid loan balance. You would owe the remainder.
For unsecured loans, non-payment damages your credit and opens you up to collections and potential lawsuit. But voluntary surrender of the vehicle is not an option since there is no collateral. The lender cannot seize your car but they can win a judgement to garnish your wages or put liens on your other assets.
Which Type of Loan is Right for You?
Before applying, consider your credit score, income, and current debt obligations. This helps you determine if you’re likely to qualify for an unsecured car loan. If not, a traditional secured auto loan is the best route and offers the most affordable financing in most cases.
Unsecured loans make sense on a very limited basis – like purchasing a rare collectible car or wanting to own your vehicle free and clear. For most people though, a secured car loan with better rates and flexible terms is the smarter choice.
Understanding the difference between unsecured vs secured auto loans allows you to weigh the pros and cons and make the best decision for your situation. Be sure to compare multiple lender quotes to find the most competitive interest rates and loan terms.
Downsides of unsecured car loans
Though these loans offer convenience and less fear of repossession, they do have downsides compared to the traditional secured auto loan.
- These loans often come with higher interest rates since they are riskier for the lender.
- You may only qualify for a shorter loan term, which could make the monthly loan payments affordable.
- The lender could sue you to recoup the unpaid balance if you fall behind on loan payments.
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Why Getting a Car Loan Is a Bad Idea
FAQ
Is a car loan secured or unsecured debt?
What qualifies as unsecured debt?
How do you know if your car loan is unsecured?
What are considered unsecured loans?
What is an unsecured car loan?
An unsecured auto loan — or a personal loan used to purchase a car — requires no collateral. Instead, if the borrower can’t pay, creditors can report the default to the credit bureaus and go to court to force collection since there is nothing to be repossessed. An unsecured car loan is a personal loan used to purchase a new or used car.
Is a car loan a secured debt?
Usually, a secured debt is secured by the asset purchased by the proceeds of the loan. A car loan is secured by the car. Sometimes, the proceeds of the loan may be used for some other purpose. For instance, you could use money from a home equity loan or home equity line of credit to pay off an unsecured credit card or medical bill.
Why do lenders issue unsecured loans?
Lenders issue funds in an unsecured loan based solely on the borrower’s creditworthiness and promise to repay. Because secured debt poses less risk to the lender, the interest rates on it are generally lower. What Is Secured Debt? Secured debts are those for which the borrower puts up some asset as collateral for the loan.
Are loans secured or unsecured?
Loans may be secured or unsecured. Secured loans require some sort of collateral, such as a car, a home, or another valuable asset, that the lender can seize if the borrower defaults on the loan. Unsecured loans require no collateral but do require that the borrower be sufficiently creditworthy in the lender’s eyes.