If you're looking for financing for big-ticket purchases, two common types are personal loans and car loans. Auto loans are a form of financing you take out if you are in the market to buy a car.
Personal loans, on the other hand, can be used for pretty much anything, from taking care of an emergency expense, consolidating debt, funding a home renovation project or paying for a vacation or wedding.
We'll dig into the major differences between a personal loan and car loan, and which type of financing you should get.
How does a personal loan work?
A personal loan is an installment loan, meaning you'll get a lump sum upfront. Personal loans are usually unsecured, so you won't have to offer a form of collateral that the lender can seize should you fall behind on your payments.
Because personal loans are unsecured, they typically have higher interest rates than secured forms of financing, such as car loans or home equity lines of credit (HELOC). You also usually need strong credit to get approved for the best rates on a personal loan. You can expect less favorable terms and higher interest rates if your credit score is less than stellar.
A major draw of personal loans is that they can be used for pretty much anything, from sprucing up your home to covering emergency expenses, or tending to a financial shortfall due to a job loss. Personal loans can also be used to consolidate debt.
Let's look at some pros and cons of personal loans:
Pros and cons of personal loans
Pros
- Versatile. A major advantage of personal loans is that they can be used for almost anything.
- Flexible. Personal loans feature flexible terms where you can usually pick your repayment terms. This can help make them more affordable.
- Stable. Because personal loans usually come with fixed interest rates, your monthly payments will be the same throughout the loan.
- High borrowing limits. While this depends on the lender, your credit and financial situation, such as your income and debt-to-income ratio (DTI), borrowing amounts for personal loans can fall anywhere from a few thousand dollars to $100,000.
- Unsecured. Most personal loans are unsecured, so you don't risk losing your car if you fall behind on your payments.
Cons
- Higher credit scores are needed. Because personal loans are unsecured, which poses a greater risk to lenders, they usually require higher credit scores and lower debt-to-income ratios.
- Fees and penalties. Depending on the lender, you might be obligated to pay application and origination fees on your loan. These are upfront costs and usually are taken out of the loan amount. Origination costs can be anywhere from 1% to 5% of the loan amount.
- The lender might also charge you a prepayment penalty, a fee for paying off your loan early. Since the lender loses money on interest, they might hit you with an additional charge.
- Narrow use of funds. Like a personal loan, a car loan is a type of installment loan, which means you are approved for a certain amount and receive the proceeds upfront to cover the costs of the car. Unlike a personal loan, you can only use a car loan to purchase your car.
How does a car loan work?
Car loans can have fixed or variable interest rates. A fixed interest rate means the interest rate is the same throughout the term of your loan, and you'll pay the same amount each month. A variable interest rate can go up and down depending on changes in the market. Variable interest rates mean your interest rate and monthly payments can fluctuate.
Another thing to consider with a car loan is that there needs to be more flexibility in terms. The average length of a car loan is now 70 months, or about six years. If you have a shorter term to pay off your loan, your monthly payments will be higher, but you'll pay less interest throughout the loan.
Car loans are backed by your car. So if you can't hold up your end of the financial agreement, the lender can seize your vehicle.
Let's take a look at the pluses and minuses of a car loan.
Pros
- Easier to qualify for. A car loan could be easier to qualify for than a personal loan. Lenders might approve you for a car loan if you have lower credit or a higher debt-to-income ratio.
- Stability. If you get a car loan with a fixed interest rate, you can enjoy steady, predictable payments throughout your loan.
Cons
- Need to offer collateral. While having your car loan backed up by your car can help you get approved for a lower interest rate, you risk losing your vehicle should you find yourself struggling to make payments.
- Expensive monthly payments. Your monthly payments depend on your loan amount, interest rate and repayment term, but according to research by Edmunds, monthly payments on a new car loan averaged $736 in Q3 2023.
Personal loans vs. auto loans comparison
| Car Loan | Personal Loan | |
|---|---|---|
Use of funds | Only toward the purchase or refinance of a car | Flexible; can be used for most anything |
Type of credit | Installment loan | Installment loan |
Fixed or variable interest rate | Can be fixed or variable | Typically fixed |
Unsecured or secured | Secured | Unsecured |
Which one should you get?
If you're debating whether a car loan or personal loan is better for your situation, the first question to ask yourself is, how do you want to use the funds?
If you want to use the loan proceeds exclusively to buy a car, then a car loan will likely have lower interest rates than a personal loan. If you want to use the funds toward something else, such as for home improvements or to consolidate debt, then a personal loan is better.
It's always a good idea to shop for rates and get quotes from a few lenders. That way, you can look side by side at the rates, terms and fees before deciding.
Frequently asked questions (FAQs)
Is it better to get a personal or auto loan for a car?
In many cases, it's better to get an auto loan for a car. While it depends on your credit score, debt-to-income ratio and other factors, and the length of your loan, auto loans usually feature lower interest rates than personal loans. While your money payments might be on the higher end, you could be paying less on interest over the life of the loan than if you financed with a personal loan. Using a personal loan to pay off your car means you'll need excellent credit to get approved for a lower interest rate. If your credit could be better, you'll pay higher interest.
Can you use a personal loan to pay off a car?
You can use a personal loan to pay off a car, but you'll need a strong credit score to get approved for a loan with lower interest rates. That's partly because unsecured loans mean you don't need to offer your car as collateral. As car loans require you to put up your car as collateral, it's usually easier to qualify for a loan with a lower interest rate.
Do auto loans hurt your credit score?
When you first take out a loan, car loans can hurt your credit score. Lenders do a hard pull on your credit, which can bring down your credit score. While hard credit inquiries usually stay on your report for two years, they typically impact your score for just the first year.
Auto loans can also hurt your score if you fall behind on your payments. Being timely with your payments and paying off the balance can improve your score.
This story was written by NJ Personal Finance, a partner of NJ.com. The information presented here is created independently from the NJ.com editorial staff, and purchases made through links in this article may result in NJ.com earning a commission.
