If you are planning on buying a new car, there’s a good chance that you will need to finance at least part of the purchase. Financing allows you to borrow some (or all) of the money for a large purchase and pay it back to the lender over a set period of time. Lenders will charge you interest, which is essentially the fee for borrowing money. So how do interest rates work on car loans?
Let’s talk about how interest rates work on car loans.
How do car loans work?
Car loans are very simple in principle. If you want a car that you cannot afford, a bank will loan you the money to purchase the car. You will get to take the car home and drive it as if it’s your own, but it is technically an asset of the bank. When you pay back the money that you owe your lender, plus the interest that accrues over the life of the loan, the bank will sign the title over to you and you will officially own the car.
What is an interest rate?
Interest is the cost of borrowing money from a lender. There are three different types of interest rates which are all calculated in different ways.
Simple interest (also known as regular interest) is based on the outstanding principal.
Example: You borrow $1,000 with a 5% annual interest rate, you would pay $50 per year in interest.
Accrued interest accumulates and is unpaid until the end of the payment period.
Example: Every month you are required to pay $60 in interest. Every day you accrue an additional $2 in interest and when you hit the $60 interest total the payment is due.
Compound interest is paid on the total of the principal and the already accrued interest.
Example: You borrow $10,000 with 5% interest and have $200 in accrued interest. Your annual interest would be $510: ($10,000 + $200) *.05
How do car loan interest rates work?
Car loan interest rates are almost always simple interest rates. A borrower is offered one fixed rate for the duration of their car loan. As the borrower pays down the principal, the amount of interest that they pay decreases until they have paid the loan back entirely.
In some cases lenders may use precomputed interest. This means that at the start of your loan they determine how much you will pay in interest and your payments will be divided evenly. If you pay off your loan early, you will still be required to pay the predetermined interest, so you will be unable to save money as you would with a simple interest rate.
Is APR the same as interest rate?
When it comes to car financing, the terms “APR” and “interest rate” are often used interchangeably. But this is not correct and they are not actually the same. The interest rate is the cost of borrowing the money, while the APR (or Annual Rate Percentage) is the interest rate plus any additional loan fees for which you are responsible. These fees, also referred to as “prepaid finance charges” can vary widely from lender to lender. They typically cover costs associated with underwriting their loans and doing the necessary paperwork.
What factors affect the interest rate you will be offered?
The car loan interest rate that is offered will be based on a number of different factors, including the market rates and the credit worthiness of the applicant. Here are some of the factors that affect the interest rate offered:
Your credit score
Your credit score is the biggest factor that is within your control when it comes to what interest rate you will be offered. Your credit score is an indicator of how likely you are to make on-time, full payments every month. The better your score is, the better candidate you are for a car loan. The best interest rates will be offered to applicants with strong credit scores.
Your debt-to-income ratio
Your debt-to-income ratio is another huge indicator of how likely you are to repay your loan. If you have a lot of debt compared to how much money you make, you are considered less likely to repay your loan.
The market conditions
The credit score you are offered will also be based in part on the prevailing rates at the time. If interest rates are high in general you can expect to be offered a higher rate than at other times.
The vehicle you are buying
The vehicle you are buying will also impact the interest rate you are offered. The most important factor is the age of the car. The older the car is, the higher the interest rate will be.
Your down payment
The size of your down payment will also have a large impact on your interest rate. The larger your down payment is, the less likely your loan is to become underwater (meaning you owe more money to your lender than the car is worth).
The loan term
A longer loan term will generally mean a higher interest rate. It will also mean that you will pay more interest over the life of the loan because you will be paying interest for a longer time. Your monthly payments will be lower because they will be stretched out over a longer period of time, but you will (quite literally) pay for this in the long run.
How can I get the best car loan interest rate?
Securing a low car loan interest rate will mean big savings in the long run, so it’s important to do your research and prepare as much as possible when buying a car. To get the best car loan interest rate possible, prepare by doing the following:
- Work on improving your credit score.
- Request a copy of your credit report and review for any errors.
- Pay down debts where you can, focusing especially on loans with high credit utilization ratios.
- Save additional money so that you can make a more sizable down payment.
- Get preapproved before heading to the dealership.
- Apply with several lenders (3-5) so that you can compare the offers.
- Avoid selecting a long repayment period if you can.
- Be sure that the car you are purchasing will fit into your budget.
That’s everything you need to know about car loan interest rates.
If you are planning to buy a new car it is important to understand how car loan interest rates work and how you can get the best rate possible.
If you already have a car loan and are unhappy with your current interest rate, contact Auto Approve today to find out how much car loan refinancing can save you!