Should you take out a personal loan or an auto loan to pay off your car?

If you're in the market for a new car but don't have enough cash on hand to buy it upfront, you're likely thinking of taking out a loan to help finance your purchase. Depending on your situation, an auto loan or a personal loan could each be an ideal financing option.

Both personal loans and auto loans are considered to be installment loans, meaning you'll be making fixed monthly payments over a set period of time. That said, there are several key differences between the two types of lending products that are worth knowing about.

Below, Select breaks down everything you need to know about using a personal loan versus an auto loan to buy a car, with a closer look at how interest rates, eligibility requirements and loan terms vary between the two.

The most obvious difference between personal loans and auto loans is that personal loans can be used to finance any type of purchase whether it's wedding expenses, home repairs or a new car. Personal loans can also be financed through lenders, credit unions and banks. If you want more flexibility when it comes to what you're using the money to finance, a personal loan is a good choice.

Auto loans, on the other hand, can only be used to purchase a vehicle and are usually financed through a bank, credit union or other lender. You may also be able to go through a car dealership, which will typically partner with other lenders to provide you with a loan, although it can be a more expensive option. Automobile loans also require a down payment, or a percentage of the value of the loan, and a larger down payment on a loan means having a lower principal to pay off later on.

Another major difference between them is that personal loans are unsecured loans whereas auto loans are considered secured loans. In other words, auto loans are backed by collateral — in this case, the car — while personal loans are not backed by anything. If you do decided to go with an auto loan, a lender can seize your car if you default on your payments. If you fail to make payments on a personal loan, however, your credit score will take a hit and the lender could pursue legal action — which could eventually lead them to seizing your assets, including your car.

Since personal loans are mostly unsecured, they require you to have a higher credit score in order to qualify for one. Generally, you'll need to have a good credit score, or a score of above 670, to be eligible. There are, however, some lenders who will provide personal loans to people with bad credit, although these kinds of loans will carry higher interest rates.

If you do have good credit, there are many personal loans available with lower interest rates and no late fees, early payoff penalty fees or origination fees. Select ranked LightStream Personal Loans, PenFed Personal Loans and Discover Personal Loans as some of the best personal loan lenders.

Another thing to consider: Personal loans will typically have repayment terms of one to seven years, while auto loans tend to have repayment periods of two to seven years. If you take on a loan that has a longer repayment term, it might have a lower interest rate but you could end up paying more in total interest than you would with a loan that has a shorter repayment period and a higher interest rate. Use a loan calculator to determine how costly your loan will be.

Both types of loans sometimes tack on an origination fee, which is represented as a percentage of the loan amount that you pay to the lender for making the loan. Personal loans tend to have slightly higher origination fees but there are many lenders that offer personal loans without these, such as the three lenders mentioned above.

Generally, it's advisable to use an auto loan to finance the purchase of a car because these types of loans tend to have lower credit score requirements and offer lower interest rates. According to a recent report by the Federal Reserve, the average interest rate for a 24-month personal loan in May 2022 was 8.73% while the average interest for a 60-month auto loan was 4.85%, so there is definitely a difference.

Still, it's worth looking at what type of terms you qualify for on both types of loans. Then consider the one with the lowest fees and interest rate, as well as the one with the best repayment period.

Choosing between a personal loan and an auto loan to pay for a car really comes down to what your financial needs are. If you're looking for a loan with a lower interest rate and don't have the best credit score, an auto loan is a great choice. If, however, you're looking for a loan you can use for purposes beyond purchasing a car, a personal loan is a good option since you can use that money toward any number of expenses.

Catch up on Select's in-depth coverage of personal finance, tech and tools, wellness and more, and follow us on Facebook, Instagram and Twitter to stay up to date.