Buying a car is one of the biggest purchases many people make. Often, an auto loan is the first place people look for financing, and it does have some benefits—like a low interest rate, for example. But an auto loan isn't the only way you can finance a car purchase. Some people choose to obtain a personal loan from their bank or credit union, which doesn't require any collateral.
Learn more about your options for financing so you can choose the source that will give you the best bang for your hard-earned buck.
What's the Difference Between Personal Loans and Auto Loans?
|Personal Loans||Auto Loans|
|May need higher credit score||May qualify with lower credit score|
|No need to use collateral||Car serves as collateral|
|No incentives offered||May offer incentives|
|Higher interest rates||Lower interest rates|
|Potential to lower interest rate by negotiating with bank||Potential to lower interest rate by comparison shopping|
If you are leaning toward a personal loan, your credit score may have to be higher—usually around 670 or higher—than if you want to get a car loan at a dealership.
At a car dealership, it may be more convenient to obtain an auto loan. First of all, it is convenient, as you are already there doing your shopping. The dealer can offer you on-the-spot financing when you buy your car. If you have so-so credit, it may be easier to be approved.
One of the biggest advantages of getting a personal loan is that there may be no collateral involved. You agree to the terms of the loan with the bank and the bank accepts your signature. The loan is an unsecured loan. Your car is not used as collateral, so if you can’t make the payments, the car is not taken away from you.
However, when you buy a car using an auto loan, you are taking out a secured loan and the collateral is the car you are buying. If you miss a payment, you are in danger of having your car repossessed.
Banks or credit unions offering personal loans don't have any special incentives for customers taking out personal loans.
On the other hand, many dealers offer incentives to buyers who use an auto loan. The dealer may be able to offer low-interest-rate financing due to comparison shopping, or even 0% financing, that a bank or credit union can’t compete with. However, you may need a very good credit score to qualify for these deals.
The interest rates and annual percentage rate (APR) may be higher when using a personal loan. That's because the bank does not require collateral and the loan is unsecured. The higher interest rate compensates the bank for the increased risk.
When using an auto loan, the interest rate is likely to be lower because the loan is secured, using your car as collateral.
Lowering Your Interest Rate
Whether you get a personal loan or an auto loan, you may be able to lower your interest rate.
With a personal loan, you may already have a relationship with your bank or credit union. That relationship may help you negotiate a better interest rate on the loan. It also may serve you well if you are late on a payment or miss a payment entirely.
With auto loans, on the other hand, you get the benefit of comparison shopping to get the best deal. Car dealers have a network of banks from which they find financing for customers.
Which Is Right for You?
To determine which type of financing is right for you, look closely at your needs and how each type of loan operates.
If you have a lower credit score, want a lower interest rate, are looking for incentives like 0% down financing, and don't mind the car serving as collateral, an auto loan might be right for you.
However, the dealer may have to mark up the price of the car in order to make any money. The increase in the price of the car may not compensate for the lower interest rate you might get from the dealer. It may make more sense to negotiate a deeply discounted price with the dealer and pay for the car with a bank loan if you can qualify.
If you have a good relationship with your bank or credit union and a higher credit score, you may be able to get similarly low interest rates from a personal loan.
If you're trading in your old car, you will likely want to go with an auto loan; it may score you a deal when it comes to paying for your new car. It may not be useful in the case of a personal loan.
Your Income Is Also Important
Your income is just as important as your credit score and credit history. Both a banking institution and a car dealership will use the debt/income ratio in order to evaluate how much total debt you have relative to the income you make both before and after your car loan.
So, when shopping for a car—regardless of the financing you choose—be sure the car you want is within your budget. Your lender may also evaluate the loan/value ratio, which is the amount you ask to borrow relative to the value of the car, to see if you can afford the car.
The Bottom Line
Personal loans might be the right choice if you have a good relationship with your bank or credit union. But for many, the lower interest rates that come with an auto loan are the deciding factor. Be sure to keep your personal situation in mind when determining which type of financing is right for you.