Next to a home, your car may probably be one of the most expensive purchases youll make in your lifetime. And if youre like most people, youll change vehicles a few times in your lifetime. But lets face it, most of us dont have the money to pay for a car or truck outright, which is why we rely on financing to purchase them. Some people may take advantage of financing deals from the automaker while others go to outside lenders. Whichever option you choose, you will have to pay interest on the loan.
But before you sign anything, its important to know how interest rates work on these loans. Getting an auto loan for a longer term with lower interest rates may keep the monthly bill below a budget-busting level, but is it a good deal for you? To answer that question, you need to understand how interest rates on car loans work.
When it comes time to finance a new or used car purchase one of the biggest decisions you’ll need to make is whether to get a fixed or variable interest rate on your auto loan. Both options have their pros and cons, so it’s important to understand how they work before deciding which is right for you. In this comprehensive guide, we’ll explain everything you need to know about fixed versus variable rate car loans so you can make an informed decision.
How Do Fixed Rate Auto Loans Work?
With a fixed rate auto loan, the interest rate stays the same for the entire term of the loan. Your monthly payments will be the exact same amount for the duration of the loan, typically 3-6 years.
The interest rate is determined upfront based on factors like your credit score, income, debt levels, loan term, and the lender. Since the rate doesn’t fluctuate, you’ll have predictability in your monthly budget which can make financial planning easier.
The main benefits of fixed rate car loans include:
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Predictable payments – Your monthly payment never changes, so you know exactly what to expect each month.
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Easier budgeting – With fixed payments, it’s simpler to plan your monthly finances.
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Protection from rising rates – Your rate won’t go up later even if market rates increase.
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Wider availability – Most lenders offer fixed rate auto loans
The potential downsides are:
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Higher initial rate – Lenders may charge a slightly higher starting rate since the rate won’t change.
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No chance to benefit from falling rates – You’ll be stuck at your set rate even if market rates decline later on.
Overall, fixed rate car loans offer stability and predictability. This makes them a good choice for buyers who want the security of knowing their payments will stay the same.
How Do Variable Rate Auto Loans Work?
With a variable rate auto loan, the interest rate fluctuates over the life of the loan. The rate is tied to an index like the prime rate, so it can move up or down based on market conditions.
Your monthly payments can change whenever the interest rate adjusts. The rate and payment typically only adjust once per year, but it really depends on the terms of your specific loan.
Here are some key points about variable rate car loans:
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The starting rate is based on your credit and other factors, just like a fixed rate loan.
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Your rate may have periodic caps, meaning it can only change so much at each adjustment.
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There is often a lifetime cap that your rate cannot exceed no matter how much the index rises.
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If rates decline, your monthly payment could drop to save you money.
Some potential advantages of variable rate auto loans include:
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Lower initial rate – The starting rate may be lower than fixed rates.
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Possibility of lower payments – Your monthly payment could decrease if rates fall.
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May pay off loan faster – Making extra payments when you can may help you pay off the loan early.
Some potential disadvantages are:
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Unpredictable payments – Your monthly payment could change, making budgeting tougher.
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Risk of payment increases – Your payment will rise if interest rates go up.
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Harder to qualify – Lenders may have stricter approval criteria for variable rate loans.
Variable rates can make sense for certain buyers, but they do carry more risk and uncertainty.
Key Factors in Choosing Between Fixed and Variable Rates
When deciding whether to get a fixed or variable rate for your auto loan, there are a few important factors to consider:
1. Loan Term
The longer your loan term, the higher the likelihood rates could rise at some point during your loan. With a short 1-3 year loan, a variable rate isn’t as risky since there’s less time for rates to fluctuate significantly.
For a longer 5-6 year loan, the stability of a fixed rate is likely the safer way to go. Rising rates could really impact your budget over a longer term.
2. Interest Rate Forecast
Pay attention to expert forecasts for interest rate trends. If rates are expected to increase notably in the near future, locking in a fixed rate could insulate you from hikes.
If rates are projected to hold steady or decrease, a variable rate could end up saving you money. Of course, forecasts aren’t guaranteed to be accurate.
3. Your Financial Situation
Fixed rate loans provide consistent, predictable payments that simplify budgeting. This can be appealing if you’re on a tight budget or don’t have much wiggle room in your finances.
If you have some flexibility in your budget and could manage higher payments if needed, a variable rate may be an option. Just be sure potential payment increases won’t stretch your finances too thin.
4. Ability to Make Extra Payments
With a variable rate loan, you have the option to pay more than your monthly amount when rates are low to pay off your principal faster. This flexibility can help you save on interest costs over the life of the loan.
If you don’t think you’ll be able to regularly make extra payments, a variable rate loan may be riskier since your minimum payment could still rise.
5. Loan Prepayment Penalties
Some lenders charge prepayment penalties if you pay off a fixed rate loan early. Be sure to find out the prepayment policy before committing to a lender, as penalties can minimize the benefit of refinancing your loan later if rates fall.
Pros and Cons of Fixed vs. Variable Rate Summary
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Tips on How to Pay Less Interest
You dont have to accept the rate thats given to you. In fact, there are ways you can avoid overpaying interest. You just have to know what to look for and how.
- Shop Around: Look at multiple lenders for attractive or time-limited offers on financing. You may find some great deals on rates and more depending on your credit score and buying demand. The interest rate environment, of course, also plays a big role in this, too.
- Time Your Purchase: If the economy is hot and rates are strong, consider waiting until the buying environment cools down. You may find lower-priced cars as well as better rates.
- Opt for a Shorter Term: Can you swing a higher monthly payment? The numbers show that shorter loan terms mean youll pay less in total interest over the life of your loan.
- Refinance: If the loan youve already got has a high rate, look for an opportunity to refinance your loan if interest rates decrease or if your credit score improves.
- Boost Your Credit Score: If your score is low or even average, take the necessary steps to improve it. The higher your score, the better the rate youll be offered. Even a small increase may help cut the interest you pay on a car loan.
- Buy a Less Expensive Car: Be realistic about the vehicle you need, what you can afford, and how much debt you really want to take on.
Eight-Year Loan at 4% Interest
If, after making a 10% down payment upfront, the balance of $40,528 is financed for eight years at 4%, the monthly payment would be $494.01. The total paid would be $47,424.67 in monthly payments, including $6,896.67 in interest. If we include the initial down payment of $4,503, the total cost of the car would be $51,927.67.
Although you lower the monthly payment by $252.37 with the eight-year term versus the five-year ($746.38-$494.01), you pay $2,641.58 more in total interest ($51,927.67 versus $49,286.09).
How I get THE BEST Current Auto Loan Rates in 2024
FAQ
Is car payment fixed or variable?
Which loan is better fixed or variable?
How do I know if my loan is fixed or variable?
What type of interest is used on a car loan?
Is a fixed rate car loan better than a variable rate?
With fixed-rate auto loans, the interest rate remains the same for the entire loan term, while the interest rate on variable-rate car loans can change periodically. Generally, a fixed-rate car loan is your best option. That’s because a variable rate auto loan carries the risk of increased monthly payments when interest rates rise.
Are car loans fixed or variable?
Now that you know the answer to the question, are car loans fixed or variable, it’s important to understand how each of these loans works. Fixed-rate auto loans typically have a loan term between 36 and 84 months. During that period, the interest rate on the loan remains the same. The average auto loan interest rate is about 6.07%.
What happens if interest rates fall on a variable-rate auto loan?
With variable-rate loans, you take the chance that interest rates might rise, which means the rate on your loan would likely go up. Some variable-rate auto loans do come with caps on interest rates, meaning the rates can only go so high, which may be helpful. And if interest rates fall, your auto loan interest rate could go down.
How does a variable rate auto loan work?
That means with a variable-rate auto loan, your rate could go up if the prime rate goes up, which would make your monthly payments higher. Lenders use the prime rate as a base to determine your interest rate for an auto loan, and they also take into consideration such factors as your income and credit score . How Do Variable-Rate Auto Loans Work?