Personal loans and car loans are two common financing options for major purchases, but a car loan is often better for buying a car.

The main difference between a personal loan versus a car loan is that a personal loan is typically unsecured, meaning it has no collateral. An auto loan is usually backed by the car, so the lender has lower risk if you default on the loan. Auto loans generally have lower interest rates. A personal loan can be used for many different purposes, including buying a car, whereas a car loan is only for buying vehicles.

Personal Loans

A personal loan provides you with funds from a lending institution like a bank in a lump sum. A benefit of this type of loan is that you can use the money at your discretion. Such spending can include paying for a vacation, wedding, or home improvement project.

Most personal loans are unsecured. However, a personal loan can be secured against an asset, such as a vehicle or home. If a personal loan is secured, the lender can seize your asset to recover its losses if you don't repay the loan.

How Interest Rates Work on Personal Loans

Generally, unsecured loans have higher interest rates than comparable secured loans with collateral. Unsecured personal loans also come with more stringent approval requirements, so you’ll need credit if you want lower rates. If your credit history is poor, you may not get approved for a personal loan.

Your credit score will influence both the loan amount and the interest rate. The better your credit score, the more likely you are to qualify for larger loans with lower interest rates.

The Terms for Personal Loans

Personal loans have a set repayment period, such as 12 months or 36 months. Longer loan terms will lower your monthly repayment, but you’ll be paying more interest over the term of the loan. Conversely, shorter loan terms mean higher monthly repayments, but incur less interest overall, since you are paying off the principal faster.

Car Loans

A car loan is secured with the vehicle you purchase. If you default on your repayments, the lender can seize your car to try to recoup its losses. Much like with a mortgage, the lender retains ownership over the asset until you make the final payment. Car loans are paid off in fixed monthly installments with varying terms and interest rates. One common car loan term is five years.

Interest Rates

Given that the lender has the collateral of the car backing the loan, the loan is considered lower risk. So, you will generally get a lower interest rate than you would on a personal loan. Interest rates are also fixed, so you will know what to expect with your monthly payments.

The Terms

Car loans are often fixed at 36, 48, 60, or 72 months. Other term lengths are possible as well. And like the personal loan, the shorter the term, the higher the monthly repayment and vice versa. A less-than-average credit history won’t necessarily prevent you from getting a car loan.

There are a variety of ways to get car loans. Before signing up for a dealer loan, shop around for car loans from your bank or credit union, which can often give you better deals.

The Bottom Line

When it comes to buying a new car, you have several financing options. Go beyond a dealership's financing offer and shop around for various loans to ensure you get the best interest rate. In most cases, an auto loan that uses your car as collateral will provide the lowest interest rates. But explore your options in using personal loans as well.