The Ins and Outs of Variable Rate Car Loans

Getting a new car is an exciting experience But financing that new car can be stressful, especially if you’re not familiar with how auto loans work. One of the biggest decisions you’ll need to make is whether to get a fixed or variable interest rate on your loan

While fixed rate loans offer predictability variable rate loans can seem tempting because of the lower initial interest rate. However there are some major risks to consider before signing up for a variable rate auto loan.

In this article, we’ll break down everything you need to know about variable rate car loans, including:

• How variable rate loans work
• The pros and cons of variable rate car loans
• Tips for getting the best deal on a variable rate loan
• Alternatives to consider

What is a Variable Rate Car Loan?

With a variable rate auto loan, the interest rate fluctuates over the life of the loan. The rate is tied to an index rate, usually the prime rate, and adjusts up or down as that index changes.

For example, let’s say you take out a loan with an initial rate of 5%, and that rate is based on the prime rate of 3% plus a 2% margin. If the prime rate goes up to 4%, your new loan rate would be 6% (the new prime rate of 4% plus the 2% margin).

The fluctuation means your monthly payments will change over time. If rates go up, your payment will increase. If rates go down, your payment will decrease.

The Pros of Variable Rate Car Loans

At first glance, a variable rate loan can seem very appealing:

• Lower initial rates: Variable loans typically start with a lower interest rate than fixed rate loans. This results in a lower monthly payment to begin with.

• You can benefit when rates fall: If interest rates decrease, you’ll end up paying less interest over the life of the loan as your rate drops.

• Shorter loans may avoid increases: If you take out a short term loan, like 2-3 years, you may be able to pay it off before rates have a chance to rise significantly.

The Cons of Variable Rate Car Loans

However, there are some significant downsides with variable rate loans that you need to seriously consider:

• Your monthly payment can rise: While starting lower, your monthly loan payment can increase a lot if interest rates go up. This can wreak havoc on your budget.

• It’s hard to predict your total costs: With fluctuating rates, it’s difficult to determine what your total loan costs will be over the full repayment term.

• Longer loans see more risk: The longer your loan term, the more likely it is rates will increase at some point, often significantly raising your total repayment costs.

• You can end up underwater: If rates rise high enough, you may owe more on the loan than the car is worth (known as being “underwater” or “upside down”). This makes the loan harder to pay off if you need to sell the car.

• There may not be a rate cap: Some variable rate loans don’t limit how high the interest rate can go. Without a cap, you could end up with a very expensive payment.

Tips for Getting the Best Variable Rate Car Loan

If you decide a variable rate loan is still the right choice, there are a few tips to follow:

• Ask about rate caps – Be sure to find out if there is a ceiling on how high the rate can rise on both individual adjustments and over the life of the loan.

• Look at the index – Loans based on more stable indexes like Treasury notes see smaller fluctuations than those based on the prime rate.

• Compare multiple lenders – Be sure to compare offers from several lenders to find both the lowest starting rate and best rate cap terms.

• Consider a shorter term – Opt for the shortest term you’re comfortable with to limit chances of increases.

• Have a contingency plan – Understand the maximum possible payment and have a backup plan in case it rises significantly.

• Make extra payments – Making additional principal payments when possible will help pay off the loan faster and minimize interest costs.

Alternatives to Variable Rate Car Loans

If the risks of fluctuating rates seem too stressful, you may want to consider:

• Fixed rate loans – With a fixed rate, your payment amount stays the same over the full repayment term. This predictability can give peace of mind.

• Shorter loan terms – A 36 or 48 month loan limits risk compared to 60+ month loans, while keeping payments manageable.

• Buying a cheaper car – Getting a less expensive car means you can take out a smaller loan and won’t be hurt as much if rates rise.

• Using savings – For qualified borrowers, some credit unions offer low rate auto loans financed partially via savings for stability.

• Delaying your purchase – If rates are low right now, waiting to buy until they stabilize again is an option.

The Bottom Line

While variable rate auto loans may start with tantalizing low rates, the risk of rising payments down the road is substantial. Make sure you fully understand the terms of any variable rate loan offer and have a backup plan in case rates increase. For many borrowers, choosing a fixed rate loan or shorter term is the safest option. But if you qualify for good rate cap terms, have a stable budget, and plan to pay off quickly, a variable loan could save you money.