Interest Rate Basics: Financing a Car

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Finding your dream car is just one part of the car buying equation.


If you don't have the cash to buy it outright, you'll need to secure an auto loan. But from whom do you finance and how do you decide which lenders offer the best terms and rates for you and your financial situation? In this section, we highlight the basics of auto loan rates to help you find a great loan at the right rate.
 

Who sets auto loan rates?

In its simplest form, most auto loans come with fixed interest rates that are impacted by the Federal Reserve's decision to raise or lower its interest rates.  As such, when the Federal Reserve decides to increase its interest rates, monthly payments on cars increase.  Conversely, monthly payments on cars decrease when the Federal Reserve decides to lower its interest rates.
 

Are all fixed-rate auto loans created equal?

No.  Interest rates and loan terms vary between banks, credit unions, dealerships and manufacturer finance arms.  That's why finding the right financing can be confusing and downright difficult.
 

Is it wise to get pre-qualified?

When it comes to buying a car, your best bet is to get pre-approved for a loan before you go shopping.  Not only can you lock in low rates before they have a chance to increase, you can use the offers you received as a negotiation tool with the dealership, if its rates are higher.  What's more, it's good practice to focus on getting the best possible sales price for a car first, and then discussing financing with the dealer later.  Getting pre-qualified for a loan helps you do just that.
 

Do dealers offer the best auto loan rates?

Since a majority of the car buying process — from the test drive to the completion of DMV paperwork — is handled there, dealer financing is very convenient.  But convenience comes with a price.  Dealers actually make money on financing by tacking onto loans added fees and extra percentage points that, in turn, become the dealer's commission when he sells the loan to another lender. Hence, the higher the additional fees and extra interest, the higher the dealer's profit.

Regardless, it's still possible to find good dealer financing programs. Don't sign on the line until you look at the entire picture, however, including the total price of the car, the interest rate you're quoted, any additional fees that accompany the loan, your down payment and the length of the loan.
 

Can I save money on auto loan rates with a HELOC?

If you qualify, there are advantages to using a home equity loan or a home equity line of credit (HELOC) to purchase a car.  For starters, home equity loans usually come with lower interest rates than standard auto loans because they're borrowed against the equity in your home as collateral which drives down the interest costs.  What's more, you might actually be able to deduct the payments if you itemize them on your federal tax return.  Be sure to consult a tax advisor to determine if this is a smart approach for you. 

A HELOC usually comes with the lowest rates but it's a riskier proposition.  HELOC rates are variable which means you're stuck with a higher monthly payment should interest rates increase.  While a HELOC makes sense for loan terms of 36 months or less, financing over 36 months is better suited for fixed rate home equity loans.
 

Can I save money with variable-rate loans?

Adjustable loans usually come with lower interest rates than five year fixed-rate auto loans because they're tied to the prime lending rate which is the benchmark banks use.  In stable or declining interest rate environments, variable-rate loans are particularly effective.  In general, adjustable auto loans are usually harder to find than standard fixed-rate auto loans.
 

What if I refi?

It's smart to consider refinancing your auto loan if rates are declining.  Even though the savings aren't huge, the upfront fees to refinance aren't huge either.  As an example, a drop in interest from 7.5 percent to 5.5 percent on a $20,000 four year loan would save you $18 a month.

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