January 29, 2022 – By Kat Tretina
The prices of both used and new cars have skyrocketed in the past year, due to production shutdowns during the pandemic and inventory shortages as demand outpaced supply. The average price Americans paid for a new car increased by $6,220 in 2021, according to Kelly Blue Book. In December 2021, the prices for new cars reached all-time highs, with the average final transaction price being $47,077.
If you can’t afford to shell out that much money upfront, you’re not alone. In 2021, the average amount consumers financed was $37,280 for new cars and $25,909 for used cars, according to a report by the credit bureau Experian. With financing, you can purchase a car without much cash upfront and pay back the loan over a set amount of time, usually two to seven years.
If you’re looking to finance a car, you have two main options available: auto loans, which are specifically used to finance cars, and personal loans, which can be used for almost any purpose, including buying a car. While they each have their pros and cons, an auto loan is usually the best option for most consumers. However, there are some circumstances where a personal loan could make sense.
Here’s what to know.
Differences Between Personal and Auto Loans
When you’re shopping for a car, you have two main options for financing: personal loans and auto loans. Personal loans can come from banks, credit unions or online lenders. Auto loans can come from several different sources, including manufacturers and dealerships with in-house financing as well as banks and credit unions.
The biggest differences between the two loan types are their intended uses and whether they’re secured or unsecured.
“An auto loan is a secured loan, as the car is used as the collateral,” says Madison Block, senior marketing communications associate with American Consumer Credit Counseling, a nonprofit credit counseling agency. “While some personal loans may have some form of collateral, it’s more common for personal loans to be unsecured,” she explains.
In general, secured loans tend to have lower interest rates since the lender can repossess and sell your collateral if you default, which reduces the lender’s risk. Keep in mind, though, that the exact rate you get will depend on your credit score, income, and the lender you choose.
Car loans are designed specifically to purchase vehicles, while personal loans have fewer restrictions or limitations. “A personal loan can be used for a variety of different purposes, whereas an auto loan is strictly to buy a car,” says Block.
| PERSONAL LOAN | AUTO LOAN | |
|---|---|---|
| Where to get one | • Banks • Credit Unions • Online Lenders |
• Banks • Credit Unions • Dealerships • Manufacturers • Online Lenders |
| Typical APR range | 2.49% to 35.99% | New car: 2.58% to 12.99% Used car: 3.68 to 19.85% |
| Typical loan term range | 24 to 84 months | 24 to 84 months |
| Typical loan amount range | $1,000 to $50,000 | $4,000 to $100,000 |
| Potential fees | Origination fee | Origination fee Dealer fee |
| Down payment required? | No | Sometimes |
| Secured or unsecured? | Unsecured | Secured |
| Limitations? | None | May have restrictions on vehicle mileage and age |
| Cosigner typically allowed? | No | Yes |
Pros and Cons of Using an Auto Loan to Finance a Car
For most people, an auto loan makes the most sense for purchasing a car. Because they’re secured, they’re usually easier to qualify for than a personal loan, and you may be able to borrow more money.
“You may be able to get better rates and better terms, or perhaps even a larger loan to buy a car,” says Griffin. “A secured loan gives more security to the lender, and they’re more willing to take on risk.”
Auto loans usually have lower interest rates. For example, the average interest rate for a new car loan was 4.05% in 2021, according to Experian. By contrast, the average interest rate for personal loans in that same timeframe was 9.09%, according to the Federal Reserve.
The downside? If you fall behind on your payments, the lender can take your car and sell it to recover some of their money. Also, some lenders may have restrictions on the make, model, age, and mileage of vehicles that are eligible for financing.
With an auto loan, a down payment is usually required, though exceptions do exist. On the other hand, you could theoretically get a personal loan that covers the entire purchase price of the car and pay nothing upfront. However, do know that having a down payment will save you money in the long run, as you’ll have a lower loan amount and thus pay less interest over the life of the loan.
Pros
- Easier to qualify for a loan
- Usually have lower interest rates
- May qualify for special incentive programs
Cons
- Risk of repossession
- Limitations on eligible vehicles
- Down payment usually required
Pros and Cons of Using a Personal Loan to Finance a Car
Although auto loans tend to offer more advantages for car buyers in most circumstances, a personal loan can make sense in certain situations, says Rod Griffin, senior director of consumer education and awareness with Experian.
Some auto loans have higher minimum loan amount requirements than personal loans, which means personal loans may be the better option if you only need to borrow a small amount. For example, if you’re buying a $10,000 used car and have $8,000 in cash, you could use a personal loan to cover the remaining $2,000, which you may not be able to finance with an auto loan.
“There are also circumstances where a personal loan would be appropriate for a classic car or collectible car,” Griffin adds. “Not all auto loan lenders allow for financing for those vehicles.”
Most auto loan lenders have restrictions on eligible vehicles. For example, vehicles usually need to be under 10 years old and have fewer than 120,000 miles. Older classic cars wouldn’t meet those requirements, so a personal loan could be a useful alternative.
However, personal loans may have higher interest rates than car loans since they’re unsecured. Because there is no collateral, lenders use your credit and income to determine your eligibility, so you’ll likely need good to excellent credit to qualify for a loan.
Pros
- No restrictions on vehicle type
- No collateral required
- No down payment required
Cons
- May have higher interest rates
- Stricter credit and income eligibility requirements
- Cosigners may not be allowed
Additional Considerations
When deciding whether you should use a personal loan or auto loan to finance your car, there are some additional factors you should take into consideration:
Dealer vs. Outside Financing
When it comes to auto financing, it pays to shop around. According to a 2021 study by J.D. Power, 45% of consumers do research prior to financing a vehicle — and for good reason. You may qualify for more competitive rates from your own bank or credit union than your dealer’s in-house financing department.
It can be helpful to get pre-qualified with a separate lender before you go to the dealership, to get a baseline idea of what rates and terms you can get. That way, you can better compare offers or even negotiate once you’re at the dealership.
Still, for borrowers with stellar credit and a low debt-to-income ratio, it can sometimes be worthwhile to get financing through a dealership. “It works to your advantage to let a dealer shop your loan for best rates, and you get more options,” says Griffin. Some dealers will offer discounts off the purchase price to borrowers with excellent credit who utilize dealership financing.
The best way to make sure you’re getting a good deal is to compare financing offers from multiple sources. Be sure to calculate the entire cost of borrowing — including the interest rate, fees, and any discounts — to ensure you’re comparing apples to apples.
PRO TIP
Before heading to the dealership, shop around for auto loans on your own. You may qualify for a loan with a better rate from a bank or credit union than you’d get from the dealer, and you’ll have more bargaining power.
Manufacturers’ Promotions
Depending on the make and model of car you’re buying, you may be eligible for manufacturer promotions. However, you usually have to finance the vehicle through a qualifying dealership to take advantage of those offers.
For example, you could qualify for 0% APR (or a low APR) for a set period of time, cash back, or manufacturer rebates. These offers typically can’t be combined, meaning that you may have to choose between 0% APR or cash back. Be sure to read the fine print and crunch the numbers to find out which one is the best deal in your situation.
These special financing promotions are typically only offered to those with excellent credit, and may require a down payment of a certain amount. Some offers are also only available on certain trims or models. You can check a car manufacturer’s website to see what offers are available, or ask your dealer if there are any current offers for the specific car you want to buy.
Refinancing
While auto loan refinancing is an option on the market, you shouldn’t take out a loan with a higher rate to take advantage of discounts with the idea that you can just refinance later. Some lenders may charge prepayment penalties if you pay off your loan before your original term ends, which could wipe out any savings you get from refinancing to a lower interest rate. Be sure to check your loan contract for these details.
Most auto loan refinancing companies will be reluctant to let you refinance if you’re upside down on your existing loan, meaning you owe more than the car is currently worth. As new cars depreciate quickly — roughly 20% in the first year of ownership, according to CARFAX — this may prevent you from refinancing if the payments you’ve been making haven’t been enough to cover the loss in value. And, if you don’t have good or excellent credit, you may not see a substantial difference in interest rate if you refinance.
While refinancing can be a good option if you want a lower rate on your current loan, you shouldn’t base your decisions when buying a new car on the expectation that you’ll be able to refinance the loan down the line.
Which Loan Type Is Best for Financing a Car?
When you’re shopping for a car, it’s important to do your homework on your financing options. While an auto loan and personal loan can both give you the cash you need, which one is best for you depends on your credit and the type of vehicle you’re buying. In general, auto loans will be the better option due to their lower rates and credit requirements. The exception is if you’re buying an older vehicle or classic car, or if you only need to borrow a small amount. In those cases, a personal loan could be a better fit.
No matter what type of financing you use, it’s a good idea to check your credit report and review your budget before you step foot in a dealership. “Make sure you buy a car you can afford — not just the payments but also maintenance and insurance,” says Griffin.
It’s wise to research your financing options and get some rate quotes online. Even if you don’t take out a loan directly from a bank or credit union, getting quotes ahead of time will give you an idea of what rates a dealer can offer you, giving you more power during negotiations.
“Do your research to see where you can get the best interest rates,” suggests Block. “Make sure your credit is in good shape, too. Even though you may be approved for an auto loan with poor credit, your interest rate will likely be very high.” If your credit isn’t where you want it to be, you can take steps now to start improving your credit.
