Taking over someone's car payments isn't easy or always possible. Here's what you need to know. Owning a car can be expensive. In fact, the latest data from AAA shows that the average yearly cost to own and operate a new vehicle in 2022 is $10,728 or $894 per…
Your interest rate can make – or break – your monthly payment.
For many of us, buying a car is a necessity. In places where public transit is limited or non-existent, it’s literally the only way to get around. As workers return to the office and find themselves commuting again, many factors, such as demand, inflation, and supply-chain disruptions, have driven new and used car prices to record highs.
Along with record high car prices, consumers will also have to take higher interest rates into consideration as the Federal Reserve raises rates. Although the Fed’s rate hikes don’t directly impact auto loan and refinance rates, they do ultimately change what rates lenders offer borrowers, meaning interest rates typically rise too.
If you already have a car loan and your interest rate is fixed, higher interest rates won’t impact you at all. But if you have a variable rate loan, a higher rate could mean you’ll be paying more for your same car.
Understanding Your Car Loan Interest Rate
Simply put, the interest rate on your car loan is the percentage a financial institution will charge for borrowing money. The monthly payments you make on a car loan go toward paying off the principal and covering interest charges.
Most car loans are simple interest loans — the monthly interest you pay is based on your loan balance on the day your payment is due — with fixed rates. If you pay more than the minimum monthly payment, the interest you owe and loan balance decrease. With a simple interest loan, interest is typically front-loaded and amortized.
Other car loans are precomputed interest loans, meaning that your interest schedule is calculated upfront based on the amount you’re borrowing. The amount of interest is added to your principal and then divided by the length of the loan term, usually in months.
Loan payments don’t apply to interest and principal separately. You also won’t get any significant reduction in interest for making an early prepayment or paying a larger amount in advance either.
The terms — interest rate and APR — are synonymous with car loans. Both give an idea of how much it costs to take out an auto loan, though APR may provide a clearer picture of how much you’re paying for the loan since it factors in the cost of some prepaid charges. It includes the cost of the interest charged, fees, and other prepaid expenses expressed as an annual rate over the loan term.
What Affects Car Loan Interest Rates?
Interest rates change based on these factors:
- Prevailing interest rates: The Federal Reserve sets the benchmark rate that affects how much banks charge to lend money. A higher benchmark rate means that banks will charge more to lend, so you can expect a rate increase on new loans and existing variable rate loans.
- Credit score: Your credit score is a numerical representation of your ability to pay off debt. Lenders assess credit scores to determine how risky giving you a loan would be. You may lock in a lower interest rate if your credit score has improved since your last loan application.
- Loan term: Interest rates also vary depending on the length of the loan term. Longer-term loans may come with higher interest rates than short-term ones.
- Down payment: The amount you put down upfront may impact your loan’s interest rate. You may get a lower interest rate when you make a larger down payment since there’s a lower loan amount to default.
- Type of lender: Banks and credit unions are the most common lending institutions. Often, credit unions offer more attractive rates than banks. You could also consider your car dealer’s financing option since they could have special deals on interest.
- New or used vehicle: Whether you’re buying a new or used car may affect the interest you pay on the auto loan. Used cars tend to attract higher interest rates than new cars.
Although multiple factors may affect the interest rate you can get upfront, most of them are within your control. However, there are two types of rates you may get when taking out an auto loan; a fixed rate and a variable rate.
Which one you choose can affect whether or not your existing car loan’s interest rate can change when the Federal Reserve raises interest rates.
What Is a Fixed Rate Car Loan?
Fixed-rate loans are the most common type of auto loan. As the name suggests, a fixed rate loan means your interest does not change over the life of the loan. You lock in your rate when you complete the loan paperwork, so your cost of borrowing remains the same despite changes in market conditions.
The rate you qualify for is typically represented as an APR that also factors in loan fees. A higher interest rate means you’ll make higher monthly payments, and it’s ultimately a more expensive loan.
With a fixed-rate car loan, your APR and the monthly payment will never change regardless of market conditions. On the flip side, you could miss the opportunity to save on monthly payments when benchmark interest rates are lower.
What Is a Variable Rate Car Loan?
A variable rate car loan is the opposite of a fixed rate loan. The interest rate on this loan changes based on the benchmark or index rate set by the Federal Reserve in response to prevailing economic conditions.The rate you lock in when signing the loan paperwork may change throughout the life of the loan. A variable rate loan may start with a lower rate at the start of the loan term, also known as the introductory period. If you’re taking out a short-term loan, you may aggressively pay it down before rates rise significantly. Variable rate loans may also cap the interest rate you can pay on a loan. This means that there’s a maximum rate beyond which your interest won’t exceed.
How To Pay Less Interest on Your Car Loan
Whether you have a fixed or variable rate loan, you don’t always have to settle for your current interest rate. Here are some tips to help you stop overpaying your interest.
Refinance to a fixed rate loan
If you’re stuck with a variable rate loan whose interest continues to rise, refinancing a car loan to a fixed rate loan with a lower rate may save you money in monthly and interest payments. Refinancing lets you take out a new loan with different terms to pay off your current loan.
You could extend the term on your current fixed rate loan so that your monthly payments go lower. An auto loan calculator should help you determine how much you’ll save on a refinance.
Comparison shop when refinancing
Most lenders will provide a preapproved rate and terms after you fill out an online refinance form on their website and they perform a soft credit check. Take the time to obtain quotes from different lenders, including both local and regional banks, and credit unions.
You can even use a marketplace to find the best interest rate. This is where the organization looks at various options for you and presents you with the best rate.
Be sure to calculate the interest you’ll pay through the life of your loan based on how much you want to borrow and the term length.
Choose a shorter repayment term
Shorter-term loans typically come with lower interest rates since they carry less risk of default compared to longer-term loans, so if you’re looking to refinance, this may be a good option for you.
If you’re sure you can foot the higher monthly payments that come with having a shorter-term loan, then you’ll end up paying less interest over the life of the car loan. Longer-term loans let you spread lower monthly payments over a long period at the expense of more interest over the life of the loan.
Add a cosigner
If you’re trying to refinance with a less-than-stellar credit score, you won’t get the best interest rate on your auto loan. You may be able to improve your score and get a lower rate by adding a creditworthy cosigner to your loan. By enlisting a cosigner, you’re technically borrowing someone else’s credit score to help you get approved for a loan or at a lower rate.
Make a large payment
Whether you refinance or not, making a larger payment, besides your normal monthly payments may help reduce the principal left on your loan. And since interest is calculated on the remaining principal, you’ll have a lower interest payment.
Can I Renegotiate My Car Loan Interest Rate?
You may be able to renegotiate your car loan rate if you’ve been consistently meeting your loan repayments and your credit score has significantly improved compared to when you first took out your loan.
Typically, your lender will let you negotiate your loan interest rate once every year, though they won’t advertise it outright. Check whether your lender isn’t using prepayment penalties to lock you into the current rate terms.
If a lender won’t budge to your renegotiation request, shop around with other lenders who may offer a lower rate. This may give you more leverage at the bargaining table. And if there’s no option for renegotiation on the table, you ask to refinance with a new loan with more favorable terms.
Getting the Best Auto Loan Rate
Even with a fluctuating interest environment, you always want to have the best rate locked in. Start by shopping around to compare refinance rates from banks, credit unions, your dealer, and online lenders.
If your credit score hasn’t improved much from your last loan application, adding a cosigner to your loan may help you get one foot ahead. Sometimes, getting the best interest rate may be as easy as renegotiating your current rate or refinancing to get a lower rate.