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Personal Loan vs Auto Financing

| Money Rates Columnist
min read

auto-loansYou may need a car, but that doesn't mean you have to buy it with an auto loan. You may want to consider the personal loan vs auto financing. For many, traditional auto financing offers lower interest rates and is the best choice. But not for everyone. Personal loans offer significant advantages that make them the best choice for some borrowers:

  • Use a personal loan for your down payment to get better auto financing terms
  • Access to cash-only bargains from private sellers or small dealers
  • Protect your work transportation from repossession in the event of default

Before buying a car, then, it makes sense to compare personal loans vs car loans. The benefits of a personal loan may surprise you.

Shop personal loan interest rates

Auto Loan Interest Rates

Your credit score really drives what you pay for auto loans. Crediting Reporting Agency (CRA) Experian lists five basic credit categories, though other sources might define these categories differently.

  • Super Prime - 781-850
  • Prime - 661 - 780
  • Non-prime - 601-660
  • Subprime - 501 - 600
  • Deep Subprime - 300 - 500

An auto loan is probably the most unusual bit of financing you will find. There are millions of auto loans originated every year and yet they are very different from mortgages, student loans, and credit cards. These differences mean that it can be difficult to get the best rates and terms and for that reason you might want to consider a personal loan rather than an auto loan.

Auto Loan Consumer Protections

Let's start with the idea of consumer protection. Much of the financing that comes your way includes a number of consumer protections established under the Dodd-Frank legislation from 2010. However, car loans originated by auto dealerships are excluded from Dodd-Frank.

Not only are financial regulators barred from directly overseeing auto finance, they're even barred from indirect oversight under legislation passed in 2018.

In fact, auto financing by itself is a huge business. According to the Federal Reserve Bank of New York in the third quarter of 2019 vehicle owners owed $1.32 trillion in transportation financing. In comparison, credit card debt was $880 billion.

What actually happens is that an auto dealership originates the financing for the vehicles it markets in then sells the loan into the financial system. The dealer thus has the opportunity to make a profit selling the car and through its financing. This is very different from, say, a home seller. The property owner hopes the buyer will get the best possible mortgage with the lowest rate because that will make it easier to sell the house.

What Makes Auto Loans Different?

Another curiosity with auto loans is that in many cases the cost of financing is not based on the calculation of simple interest. Instead, auto finance often involves the rule of 78s.

With this type of interest calculation interest cost for the loan is pushed to the start of the repayment process. There is little benefit to prepaying the loan because much of the interest is earned, due, and payable upfront.

Figuring out how the rule of 78s works is not easy. The state of Mississippi explains it this way.

"The Rule of 78s is also known as the sum of the digits. In fact, the 78 is a sum of the digits of the months in a year: 1 plus 2 plus 3 plus 4, etc., to 12, equals 78. Under the rule, each month in the contract is assigned a value which is exactly the reverse of its occurrence in the contract. Hence, the 1st month of a 12-month contract gets the value of 12, the second month 11, etc., until the 12th month gets a value of 1. As the months elapse, the interest is earned by the lender equal to the total value of the expired months.

"For example, prepaying after 2 months of a 12-month contract would result in the lender being able to keep 29.49% of the finance charges (1st month 12 plus 2nd month 11 = 23/78 or 29.49%). In another example, if the borrower prepays after 6 months, the lender would have earned 57/78s or 73.08% of the finance charges."

Just Say No

The good news is that there are alternatives to complex vehicle financing. One option is to work with a dealer who charges simple interest. CarMax is one example. A second strategy is to avoid auto loans altogether and finance with a personal loan. Lastly, start now to bulk up your personal savings. Figure out how much you need each month for a car payment and stick that money in a savings account before you buy a vehicle.

Shop personal loan interest rates

Auto Loan Interest Rates

When it comes to defining credit card status, we often talk about terms such as "excellent," "very good," or "fair." In the world of vehicle financing, the categories have somewhat different names. With a credit score range from 300 to 850 Experian groups the categories this way.

  • Super Prime - 781-850
  • Prime - 661 - 780
  • Non-prime - 601-660
  • Subprime - 501 - 600
  • Deep Subprime - 300 - 500

It will come as no surprise that those with better credit will get lower interest rates. The difference between those with weak credit is substantial and sobering. As of this writing, rates for new cars looked like this according to Experian.

  • Super Prime - 4.01%
  • Prime - 4.96%
  • Non-prime - 7.77%
  • Subprime - 11.71%
  • Deep Subprime - 14.03%

auto loans vs. personal loans

How to Cut Your Car Payments

One way to cut monthly auto financing bills is to buy vehicles at a lower cost. This can mean the purchase of used cars. Today, used vehicle buyers might expect the rates below according to Experian, depending on their credit standing.

  • Super Prime - 4.66%
  • Prime - 6.36%
  • Non-prime - 11.01%
  • Subprime - 16.89%
  • Deep Subprime - 19.72%

Note that borrowers with deep subprime credit scores will pay almost five times as much interest as those with super prime credit records.

It might be cheaper each month to lease rather than buy. Experian reports that the average monthly lease was $452 versus $550 for a new car. However, an even better way to cut monthly cash costs is to buy used. The average monthly payment for a used vehicle was $393.

Even better, buy a car you can keep using after you've paid it off.

Dealer Financing Promotions vs Discounts

Dealers will often advertise vehicles for sale with big discounts. You might see an ad which says "buy now and get $3,000 in cash back."

Such offers are very attractive to purchaser,s but it's important to understand what's really going on.

Imagine that you buy a new vehicle and the price is $30,000 with $3,000 cashback. How much are you paying for the car? It might seem as though you're only paying $27,000 but if you take a look at the loan agreement you'll see that it's actually for the full $30,000.

In these transactions you are buying a car AND getting cash back. Notice that the dealer is not selling the car for $27,000. They're selling the car - usually a car they want to get rid of because it's selling poorly or new models are about to arrive - with a special incentive.

A dealer might offer cash back or a lower interest rate. To see which option is better, you need to run the numbers, to find out the total cost of each loan option.

Rather than buying with cash-back financing or a lower loan rate why not just buy at a discount? One way to do that - maybe the easiest way - is not to depend on getting a loan from a dealer.

Buying a Car With a Personal Loan

Vehicle financing is often complicated when it doesn't have to be. If you need dealer financing, you have less leverage when trying to negotiate a vehicle price. The alternative is to walk into the dealership with financing in hand, either cash or financing from a non-dealer source.

You don't need the dealer for financing. That means the terms of the deal can be very much clearer. The price you pay for the vehicle is really the price you pay, not the price plus strange interest calculations, quirky cash-back arrangements, or hidden fees and charges.

One approach is to use a personal loan. A personal loan is very simple financing. A typical personal loan is a fixed interest rate and set monthly payments. They can usually be prepaid without penalty but be sure to discuss the details with lenders.

You can get a personal loan from banks, credit unions, family, friends, or through loan matching services, such as MoneyRates.

A personal loan is unsecured. It is not tied to the vehicle. A dealer or whoever owns the loan cannot repossess your car in the middle of the night leaving you with no way to get to work or school.

For more information regarding personal loans you can check this site or speak with other potential financing sources. Be sure to compare rates and terms and think about the financing which is best for you.

Compare personal loans for auto purchases

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