Financial Tips Friday - Understanding Interest Rates on Auto Loans

Interest is what you pay to borrow money from a lender when you finance the purchase of a vehicle.

·         Interest charges are included in your monthly loan payment and can add thousands of dollars to the amount you have to repay. That’s why it’s important to understand how car loan interest is calculated, what factors can affect your rate and how to minimize interest charges.

Interest rate vs. APR

·         There are two ways to express the cost of borrowing money from a financial institution — interest rate and APR, or annual percentage rate. The interest rate is how much you pay each year to borrow money, expressed as a percentage. APR reflects the interest rate plus any additional loan fees. It’s also expressed as a percentage. A higher APR or interest rate means that more money will come out of your pocket until you pay off the loan in full.

·         All lenders must disclose the APR on a loan offer. When comparing loans, pay attention to the APRs, which reflect the total financing cost. And make sure you’re comparing APR to APR, rather than APR to interest rate.

Factors that can affect the interest rate on a car loan

Your lender determines your interest rate after a review of your credit and finances. These are just some of the factors that may affect the rate you’re offered.

·         Credit scores

o   In general, people with good credit scores are more likely to qualify for lower rates than people with lower scores. Average interest rates on new-car loans for people with the highest credit scores were nearly 11 percentage points lower than for people who had the lowest scores, according to Experian’s State of the Automotive Finance Market report for the first quarter of 2020.

·         Type of lender

o   Many banks, credit unions and online lenders offer auto loans. But credit union car loans typically have lower interest rates than car loans from banks. Automakers’ finance companies also offer auto loans, and they may run special promotions. If you have excellent credit, you may be able to snag a 0% APR offer from the dealer.

·         Loan term length

o   Lenders may charge higher interest rates on loans with longer terms. And since cars depreciate quickly, you could end up owing more than your car is worth if you choose a longer loan term. It may be tempting to choose a longer term to reduce your monthly loan payment, but you could end up paying more interest over the length of the loan than if you chose a shorter term.

·         Down payment

o   Lenders may charge higher rates when you put little or no money down. This higher rate is in exchange for the risk that you’ll default on the auto loan and the lender will be left with a vehicle that’s worth less than you owe.

·         New vs. used

o   Rates on new-car loans tend to be lower than rates on used-car loans. The average interest rate on a used car loan was 9.65% in the first quarter of 2020, compared to 5.61% on a new-car loan, according to Experian’s State of the Automotive Finance Market report.

·         Interest rate environment

o   Interest rates aren’t static. They move up and down based on market conditions. When times are tough — like during the financial crisis of 2007 to 2009 — rates tend to be lower to encourage people to borrow money and businesses to invest in expanding. When the economy is strong, rates are typically higher to help slow inflation.

Originally written by Credit Karma