Personal Loan Vs. Auto Loan: Differences and Which is Better?
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Personal Loan Vs. Auto Loan: Definitions and Differences
What is a Personal Loan?
A personal loan is funding that you borrow from a financial institution, i.e., a bank, credit union, or online lender, to cover specific and usually immediate financial needs. That includes the possibility that you might be applying for a personal loan to get a car, but the format is not auto-specific. While buying a car certainly qualifies as a reason you might want a personal loan, those loans are typically borrowed to cover short-term financial needs, like covering a medical bill, filling college financing gaps, or consolidating personal debt. Personal loans are structured so that you repay them in fixed monthly payments, usually for a term between two and seven years (although the repayment term may extend further than that, depending on the lender.) Personal loans are typically an option if you can’t rely on emergency funds or savings accounts to cover a relatively unexpected cost. Personal loans may or may not require collateral like a savings account or house (they are termed secured if they do, and unsecured if they don’t). Typically, the lender’s decision to approve the loan comes after it vets your financial health, including credit score, annual income, cash flow, employment status, and household debt-to-income ratio. If your loan is secured, it may also need confirmation of your collateral’s worth.
What is an Auto Loan?
Auto loans are secured loans that are typically provided by banks, credit unions, online lenders, and auto financing companies. The lender “secures” the loan by requiring that the auto to be purchased with the loan serve as collateral for that loan. In other words, if you default on an auto loan, the lender can repossess the vehicle and use it to cover the loan costs. With an auto loan, you agree to repay the funds over a specific period of time, usually between three and seven years. Interest rates tied to auto loans are fixed. For a borrower with a credit score of 600 or higher, the average annual auto loan rate for a new vehicle is around 3.00%. For a used auto, expect to pay an interest rate of around 3.5%. Auto loan applications will usually also require a credit check, along with a review of your recent work history, household income, debt-to-income review, and a history of any loan defaults.
Factors to Review Before Borrowing Money to Buy a Car
Loan interest rate. By and large, auto loans may have a lower interest rate than personal loans. That’s mostly due to the security built into the auto loan. With an auto loan, the lender already has collateral in the form of the vehicle. That reduces the lender’s risk of losing money, which typically translates to lower interest rates. Loan fees. Both auto loans and personal loans come with fees. You should understand the fees (what they are, why they’re being charged, and in what amount) before you make any loan decisions. Common loan fees for both auto and personal loans may include origination fees (charged basically for processing the loan), documentation fees (charged by car dealerships to process an auto’s paperwork), late payment fees (charged if your payments are late), early repayment fees (which may be charged if you want to pay off your loan early), and destination/sticker fees (which reflect what manufacturers may charge to ship a new car to the dealership lot). Those fees can add up to several hundred dollars so it’s a good idea to vet them thoroughly. Down payments. Unless you’re paying cash, auto lenders require down payments. Typically, they aim for at least 20% of the cost of a new vehicle and around 10% for a used vehicle. If you’re using an auto loan, expect to be asked for a down payment based on a percentage of the vehicle’s estimated value. If you’re getting an unsecured personal loan, you won’t be asked for a down payment, though you may be asked about the intended use of the loan before you’re approved.
Pros and Cons of Using a Personal Loan to Buy a Car
Pros of a Personal Loan
No strings attached. With a personal loan, the lender doesn’t mandate how you use the loan money. While you may be required to give the reason for the loan on the application, the lender probably won’t force you to use the cash to buy a new vehicle. No collateral required. When using a personal loan to purchase a car, you frequently won’t have to provide any collateral for the loan. Better yet, your personal loan lender can’t repossess the vehicle if you fall behind on payments (although in that scenario, your credit score may suffer.)
Cons of a Personal Loan
Higher interest rates. Since personal loans are often unsecured, in which case they require no collateral, lenders may look to protect themselves with higher interest rates than they charge on auto loans. Depending on your credit, personal loan rates clock in at 5.99% on the low end and up to 20% or more on the high end. Those rates are significantly higher than the average auto loan rate, which stands at between 2.5% and 5% in 2021. Harder to get approved. Typically, personal loan applications are reviewed more diligently by lenders compared to auto loans. That’s primarily due to the unsecured nature of many personal loans. As lenders want to make sure they’re lending to a borrower who will pay the loan back, they’re more likely to take a harder stance on loan approvals and thoroughly vet the financial health of any personal loan borrower.
Pros and Cons of an Auto Loan to Buy a Car
Pros of an Auto Loan
Lower interest rates. The difference between a $10,000 loan with an interest rate of 4% and one at 8%, can amount to thousands of dollars over a multi-year period. Consequently, the likelihood that you’ll get a lower interest rate on an auto loan can be a significant factor in deciding between the two loans. Quick approval. If you have decent credit and you’re in the midst of negotiating a new car purchase with a dealer, chances are you can get a quick loan approval via the dealer’s auto financing company. While getting a quick approval is great, it’s not a good reason for you to rush into making a major financial decision. That said, quick access to an auto loan approval can prove valuable if you’ve spotted the vehicle of your dreams and want to lock down a deal.
Cons of an Auto Loan
Patience is required. Much like a mortgage borrower isn’t really the owner of the home until the loan is paid off, an auto loan borrower won’t take full possession of the vehicle title until the auto loan is fully paid off. Down payment. Auto loan providers expect a down payment before signing off on the loan deal. Any resistance you put up on the down payment could well lead to a “no” on the loan application, so it’s best to come to the bargaining table with a decent down payment before applying for an auto loan.
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