Why a Personal Loan May Be a Better Idea Than an Auto Loan When Buying a New Vehicle

Is there a scenario where a personal loan makes more sense than an auto loan when purchasing a vehicle? At first glance, you wouldn’t think so.

Take the average interest rate on an auto loan compared to a personal loan.

According to data from Experian’s State of the Automotive Finance Market [>>], the average auto loan interest rate for a new vehicle stood at 5.61% in the first quarter of 2020. Additionally, the average used vehicle loan rate was 9.65% in the same time period.

Correspondingly, the average personal loan interest rate varied more widely than did auto rates, as most personal loans tracked by Bankrate wound up in the 5%-to-20% range, depending on key issues like ability to pay, annual income, and credit score health.

“Personal loans tend to have higher interest rates than auto loans, which means you’ll be paying tons of interest on an already expensive item,” says Nishank Khanna, chief financial officer at Clarify Capital, in New York, N.Y. “When you factor in repayment timelines and monthly payments, you might find you’re paying as much as double the value of the item over the life of the loan.”

Yet Khanna isn’t bullish on auto loans as a good deal for consumers, either.

“Car loans tend to be a poor investment due to their high-interest rates and depreciating value,” he says. “When you take out an auto loan, you’re agreeing to pay interest on an asset that’s continuously losing value.”

When Personal Loans May Make Sense When Buying a Vehicle

Can personal loans fill a void for new or used car purchases? Additionally, in what scenario do personal loans make sense in a new or used vehicle purchase? These scenarios could make sense for vehicle buyers.

When you’re buying an older vehicle. Most reputable financial institutions won’t finance a car older than 10 years or with an excessive amount of mileage. “But if you’re purchasing a fixer-upper, a personal loan might be the best option available,” Khanna says.

No limitations. It can make sense to use a personal loan for a car purchase if you don’t want limitations on the car (i.e., make or year of manufacture) you wish to purchase. “Some car loan providers place limitations on the type of car you can purchase using loan financing,” says Joe Bailey, business development consultant at MyTradingSkills.com, an investment trading platform based in London, U.K.

No collateral. A personal loan is sensible when you don’t want the car you’re purchasing to be used as collateral. “Personal loans have flexibility when it comes to payment structure,” Bailey adds.

When using collateral as leverage. Banks and car dealerships want buyers to take out a proper car loan, as cars, SUV’s and trucks are depreciating assets.

“Whether new or used, as soon as you drive a car off of the lot it’s worth less money,” says Jack Choros, chief marketing officer at SophisticatedInvestor.com, a financial advice platform. “Most car loans will close in five to seven years on a new car for that reason. In that scenario, the bank takes the car as collateral, and they don’t want to have to use it as collateral after seven years because then the car is not worth nearly as much is you paid for it.”

Consequently, if you can secure a different form of collateral for yourself and get a personal loan, you might be able to get a better interest rate. “For example, if you took out a personal loan against the value of your house, you would be more likely to get a better interest rate for a longer period of time, because most houses grow in value, they don’t appreciate,” Choros says.

For legal reasons. Because personal loans are unsecured, a future default on a loan is less disruptive – and that might come in handy down the road if a buyer struggles financially.

“Lenders cannot repossess your car if you fall behind on personal loan payments,” says Kevin Haney, president of Growing Family Benefits, in East Brunswick, N.J. “Instead, they must file a lawsuit and win the case.”

According to Haney, if successful in court, a judgment can result in garnished wages or a lien placed against the equity in your home or vehicle.

“However, you can continue to live in your house and drive your car because the lien does not come into play until you sell the asset,” he says. “Therefore, people who need their auto, van, or truck to earn a living find the continuity reassuring. Future financial hardship can befall anyone.”

On the downside, because personal loans don’t involve collateral, the initial borrowing terms are less attractive, making it more challenging to finance many vehicles.

“Since lenders cannot repossess your car in the event of default, they make several adjustments to their offers to compensate for the added risk,” Haney says. “That could include charging higher origination fees and interest rates, shortening the repayment length, and lowering the amount you can borrow.”