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Buying a car usually means you need financing unless you have the cash to buy it outright. Most borrowers have a couple of choices when financing a car. They can take out a personal loanor car loan. Both loans sound similar, and both can be used to buy a car, but the similarities end there.
Here’s what you must know.
Personal Loans vs. Auto Loans: The Differences that Matter
There’s one major difference between personal loans and car loans you must know. Personal loans pay for anything under the sun (you don’t need approval for how you use the funds). On the other hand, car loans are only used to purchase a car.
Personal loans are also unsecured (no collateral), while auto loans have collateral (your car). If you default on your car loan, the lender can repossess your car. If you default on a personal loan, the lender doesn’t have anything to take, but that doesn’t mean you aren’t liable for the costs – they can come after you the money in other ways.
Understanding Personal Loans
Personal loans can be used for any purpose. They are sometimes called signature loans because you don’t have to put up any collateral for the loans. However, there are some other factors you should know about personal loans that make them different.
>> More: Best Personal Loans
Interest Rates and Terms
Because personal loans aren’t secured, lenders often charge higher interest rates and have shorter terms. They don’t want the money outstanding for too long because of the risk of nonpayment, and they charge higher interest rates to make up for the risk of default.
The terms vary by lender, but it’s most common to see personal loans with terms of 3 – 5 years at the most. If you need a longer-term, you might have to shop around.
Personal loans surprisingly often have high loan amounts. The amount you can borrow depends on your qualifying factors, but it’s not unusual to see personal loans as high as $50,000, but more commonly, they are below $10,000.
Personal loans aren’t very difficult to qualify for, but you must show that you are financially responsible. On average, you need a 670-credit score, but a higher credit score is even better. A credit score over 700, for example, will ensure that you get the best rates and terms and can borrow the loan amount you need. You must also prove your debt-to-income ratio is low, comparing your monthly expenses to your gross monthly income (income before expenses).
>> More: How to Get a Personal Loan
Understanding Auto Loans
Auto loans, as the name suggests, are to buy a car. You can’t use the funds for any other purpose, and the loan is secured by the car you buy.
>> More: Best Auto Loan Rates
Interest Rates and terms
Auto loans carry a lower risk for lenders because they are secured by the car. Because of this, lenders can offer lower interest rates. If you’ve ever seen low auto loan APRs of 1% – 2%, you’ve probably wondered how it’s possible, and it’s because the borrowers have great credit and put the car up as collateral.
Car loan amounts vary by what you can afford and the price of the car. You can’t borrow more than the car’s sales price, but you must also be able to qualify for the loan you want. Most importantly, you must prove that your debt-to-income ratio is low enough to be able to add the car payment to your monthly obligations.
Typically, you don’t need perfect credit to get a car loan, but if you do, it helps you get better rates and terms. Ideally, you’d have at least a 670-credit score, but you might qualify with a score as low as 600. It helps if you have a down payment for the car and have a low debt-to-income ratio (not a lot of debt outstanding), but there are bad credit auto lenders.
>> More: How to Get a Car Loan
When Is a Personal Loan Better than a Car Loan?
While we typically recommend only using an auto loan to buy a car, there are some instances when a personal loan is better, including:
- You don’t have a down payment for the car. Personal loans don’t require a down payment, you can use 100% of the loan funds to buy the car.
- You don’t have to worry about losing your car. While it’s always wise to pay your loans off, you won’t risk losing your car if you fall behind.
- The lender won’t tell you what type of car or what year of a car you can buy with the funds.
When Is an Auto Loan better than a Personal Loan?
A car loan is typically the best option when buying a car. Here is when it’s the better option over a personal loan:
- If you have less than perfect credit, auto loans are usually much more available and will still have affordable loan terms.
- The lender offers special financing for specific makes and models that you are considering buying.
- You have money for a down payment (you don’t need a lot) since car loans have more attractive terms and will save you money.
Is a Personal Loan the Same as a Car Loan?
It’s easy to confuse a personal loan with a car loan, but they aren’t the same thing. While you can use a personal loan to buy a car, you can’t use a car loan to do anything except buy a car. There are more restrictions with a car loan than a personal loan regarding the use of the funds, but auto loans are also easier to qualify for than personal loans.
Can I Use a Car Loan for Personal Use?
Most lenders have in common that you can’t use car loan funds for personal use. You can only borrow as much as you need to buy the car, minus your down payment. You can’t borrow more than the car’s price and use the funds for personal use.
Bottom Line: Personal Loans vs. Car Loans
Should you buy a car with a personal loan? We only recommend it in a select few situations. Ideally, you should take advantage of the secured car loan with more attractive rates and terms. If you have the option for both a personal loan and an auto loan, compare your options, including the bottom line, to see which loan costs more.
It comes down to affordability and what you can qualify for in most cases, but overall, the car loan is usually the best choice.