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If you're thinking about financing a car, you'll 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. That's 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.
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 you're 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 loan's 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, it's always wise to weigh the pros and cons before deciding between a variable or fixed auto loan.
Pros of Fixed-Rate Auto Loans
- Predictability: A fixed-rate car loan is ideal for longer-term financing because the APR and payment never change over the duration of the loan, regardless of what's happening in the market.
- Long-term benefits: Generally, the longer the loan, the more risk the market interest rate will rise. With a fixed-rate loan, you have the peace of mind that your interest rate will never increase.
- Widely available: Most car loans have fixed interest rates, and you can apply for one through a dealership, bank, credit union or an online lender. Comparing multiple quotes is a wise strategy to find the lowest rates before making your decision.
Cons of Fixed-Rate Auto Loans
- Can be more costly: In certain situations, a fixed-rate car loan may cost more than a variable-rate loan. Interest rates could dip in a slumping economy, and you'd miss out on any savings with a fixed-rate car loan.
- Potentially higher rates: A fixed interest rate minimizes a loan's risk for consumers, but it presents more risk for the bank, which means they could charge you a higher rate to start.
How Do Variable-Rate Car Loans Work?
A variable-rate car loan comes with an interest rate that may periodically change. The interest charged on the loan is tied to an underlying benchmark, usually the lender's prime rate, which can change with market conditions. If a prime rate increase causes your loan's interest rate to go up, expect a higher monthly payment amount as a result.
To determine the initial interest rate for your loan, your lender will consider the prime rate, market conditions, your credit score, income and debt levels, and other factors. A variable-rate auto loan may be a good option when you expect the rates to decline during the loan's repayment term.
Pros and Cons of Variable-Rate Auto Loans
Variable-rate car loans have their advantages and disadvantages as well.
Pros of Variable-Rate Car Loans
- Flexible rate: A variable-rate car loan may have a lower interest rate at the beginning of your loan term. If you have a loan with a short term, such as two years, or you plan to aggressively pay down a longer-term loan, your loan may be paid off before rates rise significantly.
- Interest rate may be capped: Many variable-rate car loans have an interest rate cap the loan can't exceed. You might consider a variable car loan if this so-called "ceiling rate" isn't too far above the fixed rate a lender offers you.
Cons of Variable-Rate Auto Loans
- Unpredictable: Variable interest rates are subject to change based on the prime rate, so you may end up paying more than you expect.
- Introductory rates don't last: Variable-rate auto loans often offer enticing rates to start the loan term but can end with substantially higher interest rates. If your lender doesn't have a rate cap, the interest rate could rise substantially. In some cases, you could end up underwater on your car loan, meaning you owe more on your car's loan than it is worth.
How to Choose the Best Car Loan for You
The choice between fixed vs. variable interest rates on a car loan may depend on your tolerance for financial risk and the interest rate environment when you take out a loan. Here are the factors to consider before choosing a loan:
If you prefer security and predictability, a fixed-rate auto loan may be the better car loan for you. You'll know exactly how much you'll pay each month for the life of the loan. Since the interest rate never changes, you won't encounter any surprises.
But if you prefer flexibility and you have room in your budget to pay extra from time to time, you might benefit from a variable-rate car loan. By applying more funds above your monthly payment, you might pay off your car loan early and pay less interest. Of course, you'll have to manage the unpredictability of interest rates that may go up or down at any time.
State of Interest Rates
If you expect interest rates to climb, it's often wise to lock in a fixed rate before rates go up. Conversely, if interest rates are declining, you might save money with a variable-rate loan since your interest rate will also decrease.
Generally, the longer the loan term, the more affordable the car payment. However, you'll wind up paying more in interest over the life of the loan. Whether you choose a fixed-rate or variable-rate loan, understand that longer loan terms mean you'll spend more to finance your vehicle.
As you compare car loans, you can ensure you get the best deal by paying close attention to rates, repayment terms and the total cost of the loans.
- APR: The annual percentage rate, or APR, is the cost of borrowing money, including the interest rate and fees. Typically, a lower APR means you'll pay less for a loan.
- Repayment term: The most common car loan terms are for 36, 48, 60, 72 and 84 months. Taking out a longer loan may bring down your monthly payment, but you'll pay more in interest during the loan term.
- Total cost of the loan: It's a good idea to run the numbers using a car loan calculator to make sure you're saving the most money. A loan that has a lower rate may actually end up costing more than a loan that has a higher rate but a shorter loan term. It's key to consider all factors of a loan's cost.
Your Credit May Impact Your Loan's Interest Rate
Your credit history can have an impact on the interest rate and the amount you can borrow, clearing up any issues on your credit report before you apply can help you secure a lower rate. Improving your credit can save you money on your next car purchase and other financial products.
If you don't know your credit score, get a free copy of your Experian credit report and FICO® Score☉ to find out where your credit stands right now. With your credit report in hand, you'll have a better idea of your options and what steps to take next.