In most cases, a fixed-rate car loan is the best option. That’s because a variable-rate auto loan carries the risk of increased monthly payments. Variable-rate car loans may have an advantage if you don’t plan on holding the loan for a long period.
If youre thinking about financing a car, youll find loans that come with either fixed or variable interest rates. 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. Thats because a variable rate auto loan carries the risk of increased monthly payments when interest rates rise. Longer-term variable-rate loans are especially risky because there is more time for the interest rate to rise.
When it comes time to purchase a new or used car, one of the biggest decisions you’ll need to make is how you plan on financing the vehicle. Most people don’t have tens of thousands of dollars in cash readily available for a car purchase, so they turn to auto loans to cover the cost. But before rushing into a loan, it’s important to understand the key differences between the two main types of auto loans: fixed-rate and variable-rate.
What is a Fixed-Rate Auto Loan?
A fixed-rate auto loan is a loan that has an interest rate that remains the same for the entire term of the loan. Typically auto loans are fixed-rate and have terms between 36 and 84 months.
With a fixed-rate loan, the interest rate is determined upfront by the lender based on market conditions, your credit profile, and other risk factors This rate stays constant over the life of the loan, even if market rates rise or fall Your monthly principal and interest payment will be the same each month for the duration of the loan term.
The stability and predictability of fixed-rate auto loans makes them appealing to many borrowers. You’ll know exactly what your monthly payment will be making it easier to budget. And you won’t have to worry about any payment shocks from rising interest rates.
What is a Variable-Rate Auto Loan?
In contrast to a fixed-rate loan, a variable-rate auto loan has an interest rate that fluctuates over the life of the loan. The interest rate is tied to an underlying index rate, usually the prime rate, that changes based on market conditions.
As the index rate rises or falls, so does the interest rate on your loan. This means both your monthly payment and the total interest you pay could change over time. Variable rates often start lower than fixed rates, but they carry the risk of increasing significantly.
Variable-rate loans can make sense if you don’t plan on keeping the loan more than 2-3 years or if you expect interest rates to decline. But over longer terms, variable rates become riskier since there’s more time for rates to rise.
Key Differences Between Fixed and Variable Auto Loans
When deciding between fixed and variable rate auto financing, it helps to understand some of the key differences:
- Interest rate behavior – Fixed rates stay the same, variable rates can go up or down
- Predictability – Fixed rate payments are predictable, variable rate payments can change
- Market conditions – Fixed rates don’t change with markets, variable rates follow markets
- Long-term costs – Fixed rates provide payment certainty, variable rates risks higher long-term costs
- Availability – Most lenders offer fixed rate loans, variable rate loans less common
Pros and Cons of Fixed-Rate Auto Loans
| Pros | Cons |
|---|---|
| Predictable monthly payments | Rates may be higher than initial variable rates |
| Protection from rising interest rates | You can’t benefit if rates fall |
| Works well for longer loan terms | Potentially higher interest costs overall |
| Widely available |
Pros and Cons of Variable-Rate Auto Loans
| Pros | Cons |
|---|---|
| Lower initial interest rates | Monthly payments can rise |
| Can benefit from declining rates | Unpredictable payments |
| May pay less interest if paid off quickly | Higher risk with longer-term loans |
| Usually harder to find than fixed rates |
How to Determine the Best Loan Type for You
So how do you decide what type of auto loan works best for your situation? Here are some key factors to consider:
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Your financial goals – If low, predictable payments are most important, lean towards a fixed rate. If you want flexibility and don’t mind uncertainty, consider a variable rate.
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Loan term – Longer 6-7 year loans benefit more from fixed rates. Shorter 2-3 year loans reduce variable rate risk.
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Time until payoff – The shorter your timeframe for paying off the loan, the less rate direction matters.
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Market outlook – If rates are low and expected to rise, fixed rates may be better. If rates are high and could fall, variable rates may save money.
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Your budget – Make sure your budget allows room for potential payment increases with a variable rate.
Tips for Getting the Best Auto Loan Rates
Whichever type of auto loan you choose, here are some tips to get the lowest rates possible:
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Check your credit – Good credit scores in the 690+ range will qualify you for the top rates from lenders
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Compare options – Check rates from banks, credit unions, and online lenders to find the best deals
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Reduce debt – Pay down credit cards and other debts to lower your debt-to-income ratio
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Make a large down payment – Putting 20% or more down can significantly lower your interest rate
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Choose shorter loan terms – You’ll pay less interest overall with a 3 year loan than a 7 year loan
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Have a co-signer – Adding a cosigner with good credit may help you get approved and receive better rates
The Bottom Line
When financing a car purchase, it’s helpful to understand the differences between fixed and variable rate auto loans. Fixed-rate loans offer predictable payments that won’t change. But you sacrifice the ability to benefit from falling rates.
Variable-rate loans often start with lower rates but carry the risk of increasing payments over time. Weigh the pros and cons carefully based on your financial situation and risk tolerance. Be sure to compare multiple lenders to get the most competitive rates possible.
How Do Fixed-Rate Car Loans Work?
A fixed-rate car loan has a set interest rate for the entire life of the loan, typically 36 to 84 months. Lenders calculate the interest rates they offer through risk-based pricing. In other words, a lender may charge you a higher interest rate if they believe youre more likely to default on your loan due to your credit score, income and debt levels, and other factors.
The interest rate you qualify for will be represented as an annual percentage rate (APR), which also includes the loans fees. A higher interest rate will result in higher monthly payments and will ultimately cost more over the life of the loan than a lower-rate loan. As with any financial product, its always wise to weigh the pros and cons before deciding between a variable or fixed auto loan.
Pros and Cons of Variable-Rate Auto Loans
Variable-rate car loans have their advantages and disadvantages as well.
Car Loans – What’s the difference between an Interest Rate & APR?
Are auto loans fixed or variable?
Auto and personal loans are typically only available with a fixed rate, although some lenders offer a variable rate option. One of the most popular loans in this category is the 5/1 adjustable-rate mortgage (ARM), which has a fixed rate for five years and then adjusts every year after that.
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.
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?