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If you are looking to purchase a new set of wheels and you have considered applying for a car loan, it is likely you are also wondering how a lender will determine the interest rate on the funds you’ll be borrowing. Several factors will affect your car loan’s interest rate including your financial status, your credit history, the age of the car being purchased, the length of the loan and the type of finance you are applying for.
How does interest on a car loan work?
The interest paid on a car loan works pretty much the same as the interest you would pay on a home loan. The lender will either charge a fixed or variable interest rate based on the total amount of money you are borrowing. In essence, your repayments will be a combination of paying back the principal amount (the amount being borrowed) as well as the interest being charged.
Joe is borrowing $50,000 (principal) for a car loan over 5 years and has been offered an interest rate of 6.5% p.a. Joe is going to pay the loan back monthly. In summary:
$50,000 is the amount to be paid back.
The interest is 0.065 (aka 6.5%)
The number of monthly payments is 60 (12 x 5)
In this case, the total amount payable over 5 years would be $66,250 (principal + interest). Given the principal amount was $50,000, Joe will have paid back $16,250 in interest.
Now let’s say Joe was offered a rate of 6.0%. In this instance, the total amount payable would be $65,000 with only $15,000 in interest paid.
As you can see the interest rate has a large effect on the total amount of interest payable and how much your weekly, fortnightly and monthly repayments will be.
What factors will affect your car loan interest rate?
Did you know that multiple people can apply for the exact same car loan, and all be offered a different interest rate? Why you may ask? In short, there are several factors that will affect your car loan interest rate, so let’s look at them further.
Your salary/ income
The level of your income in relation to the amount you are looking to borrow will be looked at along with the stability of your job. If you have a good income and a stable, full-time job, in most cases you will be looked upon favourably by the lender and may be offered a lower interest rate. For self-employed applicants having a registered business can help with receiving loan approval.
Your credit score
A good vs bad credit score will make a large difference to the interest rate you are offered. A high (good) credit score will increase your chances of receiving a better interest rate. Basically, a high credit score indicates that you are a lower risk to the lender. Whereas, a bad credit score will most likely mean a higher interest rate is offered, as you will be seen as a high-risk borrower. It’s always a good idea to check your credit score before applying for a loan. That way if needed, you can work on improving it prior to applying.
Another assessment a lender will look at as part of your overall financial position is your debt-to-income ratio. A debt-to-income ratio measures the amount of overall debt you have compared to the income you’ll receive over a defined period. The higher the ratio, the more risk your loan will present to your chosen lender, which may impact the interest rate offered.
Length of the loan
Depending on how much you can afford to repay weekly, fortnightly or monthly, selecting a shorter loan period could result in a lower interest rate. It will also mean that you will reduce the amount of interest paid over the life of the loan.
Deposit or down payment
Choosing to make an upfront down payment will not only reduce the amount you are borrowing and the total interest you will pay over the loan term, but it could also land you a better interest rate. Many lenders are willing to negotiate better rates with customers who put down a deposit. You’ll also find that it generally makes the loan application process easier and faster.
Age of the vehicle
The age of the vehicle will also be a contributing factor when it comes to the interest rate being offered. Older vehicles don’t hold as much resale value, so if the car is repossessed in the event you default on the loan, the lender may not be able to get back the value of the monies owing, which is why you’ll likely be offered a higher interest rate than if you were purchasing a new car.
Secured vs unsecured car finance
With a secured car loan, the car being purchased acts as security/ collateral over the loan. If you default on your loan, the lender has the right to take ownership of the vehicle to recover the monies owed. Whereas, with an unsecured car loan there is no security so the risk to the lender is greater. It’s for this reason that unsecured car loans generally have a higher interest rate and require further income and credit check requirements to be met during the application process.
How can I get a lower car loan interest rate?
The good news is that there are several things you can do that may help to lower your interest rate.
Improve your credit score
If you are concerned about your credit score or have pre-checked and discovered it is not as good as it could be, taking the time to clear existing debts and ensuring you make payments on time can help to improve your credit score over a period of time.
Take out a secured car loan
Opting for a secured car loan in most cases will help to lower the interest rate being offered since the car acts as security over the loan, therefore, reducing the risk to the lender.
Have a good savings record
Being able to show evidence of a good savings history, at least a few months at a minimum, will help to show that you are able to meet your loan repayments, even if you lose your job. Having a good amount of savings can potentially help to reduce the interest rate.
If you would like to apply for a car loan or to find out more about what interest rate you might be charged, contact one of our experienced lending specialists today on 1300 001 420.