Understanding Auto Loan Interest Rates

The auto loan interest rate works similarly at buy here pay here Cincinnati dealerships, it’s just a little higher. That means, whether you are shopping at a new, used, or independent car dealership, the concept is the same. It all starts with the financing, which is getting approved for a loan. Then, they take a look at various factors to calculate the interest rate on your auto loan.

This should provide you with a basic understanding on how auto loans work. Keep in mind, this isn’t a way to give you an exact calculation for an interest rate; it’s simply a way to understand what factors contribute to your interest rate.

Financing

Financing itself is a broad term, so what does it mean for you? In this case, it’s when a borrower (you) takes out a loan in order to pay for something that costs more than they can pay for at one time. For you, it would be a car. In order to get approved, your credit history/score gets checked. If you have a low credit score, chances are you won’t get approved from a bank or mainstream dealership; which is where BHPH and bad credit dealerships come into play.

That’s the basis of financing, and it’s quite simple. If you get approved for your car loan, then you get X amount of dollars, and are expected to pay it back in installments over a certain period of time.

How Interest Rates are Calculated

These installments come with an interest rate, and it’s important to know how these are calculated. The factors that make up the interest rate are credit history, debt-to-income ratio, and 2 different types of interest rates. So you aren’t wondering how interest rates make up the interest rate, we will cover that first. The two types of rates used are the simple interest rate and the compound interest rate. The simple interest rate is calculated using only the amount of the principle owed, and a compound rate uses both the amount owed AND the interest rate owed. Yes, you are paying interest on the interest.

As confusing as that one was, the next two aren’t so hard to understand. Your credit history is probably the biggest factor in determining your interest rate, and a higher score/better history translates into a lower interest rate. Because a higher score tells the lender you are responsible enough to pay off the loan, so you won’t get whacked with such a high interest rate.

The debt to income ratio is how much your gross monthly income goes towards paying other bills like housing and food. If your ratio isn’t satisfactory, chances are your interest rate will get bumped up a bit. This is because you are taking on another type of financial responsibility that will add to your debt-to-income ratio.

This is just a basic understanding of auto loan interest rates, but it’s enough to get you started. The more you know about your interest rate and car loans, the better off you will be when applying for one. That old adage “knowledge is power” has never been more true when it comes to car shopping.

2020 Update

While the above information is a great jumping off point for understanding auto loans in general and interest rates specifically, you probably still have some questions. Let’s dig a little deeper into some of the topics we covered earlier and try to address some of the most common questions we are asked.

Why Does a Low Credit Score Mean a Higher Interest Rate?

This is a question we get asked sometimes during the financing process no matter what kind of financing our customers are looking at, and it’s understandable. It can seem, and sometimes feel, like people with poor or little credit are expected to pay more for their vehicles and other high-value items that require a loan. This is due to a low credit score or little credit history, often resulting in loans with higher interest rates. And it can seem unfair.

In total fairness, however, you have to look at it from the perspective of the lender, rather than only from the viewpoint of the borrower. Ultimately, what a credit score is meant to represent is your history in terms of paying off your debts. The effectiveness of your score accurately reflecting that might be debatable, but that’s the idea at least. So using a credit card and paying off your purchases on time, paying back major loans with on-time payments, and minimizing your overall debt can result in having a high credit score. Missing payments, making late payments, defaulting on loans, and other activities can reduce your credit score.

When a lender looks at your credit score, what they’re ultimately looking at is what kind of risk you present as a borrower. Lenders see a low credit score, or little in the way of credit history, as being risky and so they require a higher interest rate to cover themselves for taking the risk in lending to someone with a low score. We know it can be frustrating to have to deal with high interest due to poor credit, but paying an auto loan back on time is a great way to improve your credit score and get lower interest on your next auto loan.

Why Does My Debt to Income Ratio Matter?

This is a pretty similar subject to the way that your credit score impacts the kind of interest rate you can get––for the lender, it’s all about risk. They want to know that you can pay back your loan, on time, and with few or no issues regarding monthly payments. A good lender isn’t trying to prey on anyone – they want to have a loan paid back to make money on the process.

If you already spend all or very nearly all of your money on your monthly expenses, then a lender has to wonder how you will afford the added cost of an auto loan. Once again, if a lender is concerned about your ability to make your monthly payments on time, then that means you present a risk to them as a borrower. So a higher interest rate is their way of protecting themselves against the potential for losses from lending money.

Direct Lending vs. Dealership Financing

When looking at all of your options and considering the auto loan that is best for you, it’s important to look at both major types of vehicle financing. There’s no single solution that’s right for everyone, which is why multiple methods exist. You just need to determine which one is right for you.

Direct Lending – This is when you borrow from a bank, credit union, or other financial institution directly, hence the name. You can do this by working with the financing department at a dealership, which can connect you to a lender, or by contacting lenders directly yourself. For a lot of people, starting off by talking to a bank or credit union where you’re already a member can be a great first step in getting a car loan. Since they already have a relationship with you, they might be more likely to offer you a loan than other banks, and they may give you a lower interest rate than anyone else.

Dealership Financing – This refers to when you get an auto loan from a dealership, often found with Buy Here/Pay Here financing and car loans. The dealership acts as the lender, or a financial institution owned by or partnered with the dealership does so. Either way, you work directly with the dealer for financing and typically make your loan payments to the dealership, rather than to a third-party bank or lender. Interest rates can be higher with dealership financing, but the terms are usually less strict, so people with poor or little credit can still get a loan.

Pay Your Loan as Quickly as You Can

No matter what kind of auto loan you get, the best way to pay as little as possible for your vehicle is to get as short a loan period as possible on the vehicle. In addition to this, if you can pay off your loan before the end of it, that will also save you money on interest. Since interest is charged every month, each month you can eliminate from a potential loan will save you money.

Consider a vehicle that costs $30,000. To keep things simple, let’s imagine a situation where you don’t need to make a down payment and have two different loan options available to you, both charging you 5% interest (also known as Annual Percentage Rate or APR). But one loan is for five years (60 months), and the other is for three years (36 months). For the five-year loan, you only have to pay about $566 each month, which seems great, but you pay about $3,968 in total interest––almost $4k beyond the cost of the car.

With the three-year loan, you’d need to pay about $900 a month, which is quite a bit higher, but you would pay only about $2,368 in total interest. So the difference in paying the loan off two years earlier saves you $1,600 on the vehicle. The monthly expense can certainly be a lot greater, but if you can afford to pay more each month, to pay off a loan sooner, then do so.

And remember those examples were without a down payment––if you can make a down payment, even if you don’t have to, then do so. Anything you pay off the front is not part of the loan, and you don’t pay interest on it. Let’s imagine you can pay $5k as a down payment on that same vehicle: the five-year loan would have $3,300 of interest, while the three-year loan would have just over $1,900 in interest. So you can save substantial money by making a down payment and choosing as short of a loan as possible.

What about a Lease?

In all of this, you might be wondering about a lease, compared to an auto loan. A lease is essentially a program where you don’t actually buy a vehicle––instead, you pay for the depreciation on a vehicle while you drive it for a few years. The lease agreement sets how many years you can drive it for, usually with limits on mileage, and you pay each month to offset the reduced value of the vehicle when your lease is over.

At the end of a lease, you return the vehicle, and you’re free to lease a new model or buy a vehicle. A lease isn’t right for everyone, but it is a great way to drive a new car for a few years without investing in ownership. And since you’re not buying it, the monthly payments are typically much lower than paying a loan––but you don’t own the vehicle at the end.