What is an unsecured car loan?
A secured car loan is backed by the vehicle used as collateral, while the opposite is true for an unsecured car loan. They are usually offered with terms anywhere from one to seven years
While an unsecured car loan’s purpose is still for a vehicle purchase, if you default on repayments, a lender will not automatically repossess your car like with a secured car loan. The trade-off usually comes in the form of a higher interest rate and ergo higher monthly repayments.
There are some other beenfits and drawbacks too, which you might not have considered.
Benefits of unsecured car loans
1. More flexibility with car
Secured loans generally restrict the type of car that you can buy - usually new, demo or used vehicles up to five years old. If you want to fund a slightly older car or even a classic, you might have no choice but to choose an unsecured loan.
2. Not secured
This might seem obvious, but ‘unsecured’ means more flexibility in other areas as well.
A lender offering secured loans will use guides like Redbook and Glass to determine the vehicle’s value, and if you apply for significantly more than this, they may not match what you’re asking. An unsecured loan is more focused on you, the individual, and your ability to repay the loan, rather than the vehicle you are purchasing.
3. Use the lump sum to pay for car costs
As the loan is not tied to the vehicle, you could apply for more than the vehicle’s purchase price to fund things such as insurance, registration, tyres and other car costs. This is usually not available on secured car loans. These can all add up to thousands, and on a used car chances are they will need addressing.
Drawbacks of unsecured car loans
1. Higher interest rate and repayments
The main drawback to it being unsecured is that the interest rate is often much higher as the lender assumes much more risk. It’s not uncommon for unsecured loans to be double the interest rate of their secured counterparts.
If you’re buying a new or near-new vehicle, consider that it might be a cheaper option to use a secured car loan.
2. Often more reliant on credit score
Lenders still want to minimise their risk, so if they can’t use the car as collateral, they might be more reliant on other factors, such as your credit score.
Lenders often have tiered interest rates based on your credit score. Even if you have no bad debt or no red flags on your report, you might still only have an ‘average’ credit score and have to cop a much higher interest rate.
3. If you default the lender will chase you in other ways
An unsecured loan doesn’t mean you can make-off scot free and not keep up with repayments. Rather than repossess the car, a lender will likely chase after you in other ways. This means debt collectors, and while they are legally obligated to not harass you, the volume and frequency of their communication can be annoying and stressful.
Aside from that, a lender can take you to court to recoup their costs through other means. Other means include garnishing your wages, and coming after assets other than your vehicle.
What to look for in an unsecured car loan
Beyond all the marketing, there are four key ingredients to look at that will help shape your finance decision.
1. As competitive an interest rate as possible
Unsecured loans often feature interest rates much higher than secured car loans. In this sense it is even more imperative to shop around for a competitive interest rate.
If the loan interest rate is based on credit rating, consider using a secured loan if your rating is not ‘Excellent’ as you will likely pay higher interest still.
Also look at the comparison rate, which will give an indication as to the fees payable, as explained below.
2. Low fees
Common loan fees include: establishment fee, regular account keeping fee, assessment fee, early exit fee, and extra repayment fees to name a few.
This can all add up to thousands extra on top of the regular repayments you make. Many lenders will get creative with how many fees they can charge, which maximises profit for them, while allowing them to offer a deceptively low interest rate. Ideally, you want as few of these as possible.
An easy way to look at this is through the comparison rate. A comparison rate much higher than the advertised rate usually indicates there are lots of fees to pay. While fees won’t add to your monthly repayment, it can get expensive shelling out for XYZ fee.
Look at getting the advertised and comparison rate as close to a match as possible, especially on variable-rate loans. Even if you opt for a slightly higher advertised rate, this could be worth it to avoid paying hand over fist on a myriad of fees.
For example, if you borrowed $30,000 at 8.99% p.a. over five years, this results in a monthly repayment of $623. If this had a comparison rate of 10.99% p.a. you’d be paying approximately the equivalent of $348 in fees per year.
Common extra fees on car loans include extra repayments, and a redraw facility. Extra repayments allow you to pay extra into the loan, which can significantly lower the amount of interest you will pay by shaving months or years off your car loan.
A redraw facility also can lower interest payable, but that money is able to be redrawn if you need it for a rainy day. Be aware these features might not be free, but could still be worth it if it means you will save signifcant interest.
You can see how extra repayments affect your loan using our extra repayments calculator.
4. Reconsider if it’s promising ‘fast' or ‘bad credit’ loans, or advertises repayments only
There are a few dodgy operators out there, and while most banks are safe from this practice, tread caution when you’re looking at alternative lenders.
Many lenders will advertise specifically for ‘bad credit’ loans. This can be tempting, but these often come with sky high interest rates, fees or both. ‘Fast’ loans usually mean payday lenders, which aren’t required to do credit checks or offer hardship arrangements because their loan terms are usually under 62 days and away from the eyes of the responsible lending laws.
Many dealerships also offer financing, and may express it in repayment terms only - for example ‘Get this Corolla from only $50 per week’. Repayment information without any context given to interest rate and loan term is meaningless.
The repayment might be low, until you realise you’re paying 8% p.a. over a 9 year term and forking out thousands in interest you otherwise wouldn’t have if you picked a more suitable loan.