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How Is the Interest Rate For a Car Loan Calculated?

Mayra ParisDec 1, 2017

The interest rate on your new car or used car loan is probably the most important number you will look at, apart from the actual cost of the car. The interest rate determines both how much you will pay every month and the total amount of interest you will have paid at the end of the loan term. 

The rates change every day, and they can seem a little arbitrary, but they’re not. Loan interest rates are actually calculated based on a long series of factors, from the state of the economy at large to the model of the car you want. Here, we’ve rounded up some of the most notable elements that affect that most important percentage.

  1. Monetary policy: The federal government is responsible for setting the federal funds interest rate, which determines how much it costs banks to borrow money from other banks. Their goal is to control the supply and demand of money and goods and keep the economy stable. Banks base the interest rate they charge their clients on the federal  funds interest rate, and this affects your auto loan interest rate too.
  2. Inflation: Inflation happens when prices increase and money has less purchasing power. Loan interest is one way lenders have to make a profit in the face of inflation. If prices go up, lenders will increase interest rates to make more money when the borrowers pay it back.
  3. Loan-to-value ratio: This is a measure of risk used by lenders to know how likely they are to get their money back from the borrower. It’s calculated by dividing the amount of your loan by the value of the vehicle. This ratio is one of the reasons why it is so important to make a sizeable down payment. Not only will you need to borrow less, but your interest rate may even be lower because the risk to lenders will decrease as well.
  4. Loan term: The loan term determines how many payment periods your loan will have. For a car loan, this can range from 48 months to 84 months, but the longer the term, the higher the interest rate. This is because lenders believe they are less likely to recover their money as time goes by. In the case of a used car, long loan terms aren’t usually allowed, since the lender’s risk further increases with older cars. More on that below.
  5. Credit score and credit history: Your credit score is one of the most important factors in determining your interest rate. Lenders look at your credit score and history to see if you make payments on time, if you’ve defaulted on a line of credit or declared bankruptcy, and what your recent credit history looks like. Using this information, they will determine how likely you are to pay the loan back. If you have bad credit, you will most likely get a high interest rate on your auto loan.
  6. Debt-to-income ratio: This measure of risk is also extremely important, since it shows how much money you owe compared to how much money you earn. If this ratio is very high, you will probably get a higher interest rate. Lenders will feel you are less likely to use the income left over to repay the new debt.
  7. Vehicle age: Used cars get higher interest rates for many reasons. Statistics show that used car buyers are more likely to have bad credit. In addition, it is harder to determine the value of a used car because it may have been in unreported accidents or it may have mechanical problems. Also, in the case of default, it is more difficult for a lender to resell a repossessed older car. Therefore, lenders increase the interest rate to make sure they get more money back.
  8. Vehicle model: The model of a car also factors into the interest rate. Similar to used cars, in case of a default, the lender will have to repossess and resell the car to recover their investment, and car models that aren’t very popular will be harder to resell. Therefore, less popular models will get higher interest rates than more popular models.