How Auto Loan Rates Are Calculated
Unless you’ve got a huge pile of cash stacked up and nothing else to do with it, odds are when you buy a car you’re going to need to borrow the money to purchase it. In other words, you’ll have to seek financing. If you have reasonably good credit and a steady job with verifiable income this shouldn’t be a problem.
However, keep in mind the organization loaning you the money is going to want to make a profit on the money it put at risk when it granted you the loan. The profit is called “interest”. When you repay the loan, you’ll be expected to pay back the amount borrowed, plus a percentage of that amount — usually on a monthly basis — in “installments”.
The percentage of the amount loaned is called interest. The amount of interest you’ll pay is called the “loan rate”. In most cases the interest amount is added to the original amount borrowed and the total is divided be the number of months you agreed to pay to determine your installment payment.
How auto loan rates are calculated depends upon a number of factors; Credit History, Interest Type, Debt-to-Income Ratio, Down Payment, and Loan Term.
How Auto Loan Rates Are Calculated: Credit History
Ironically, generally speaking in order to get credit for something like a car, you typically have to have had credit before. This is because lenders use your behavior with past loans to determine your eligibility for current and future loans.
In most instances, when evaluating a credit history, a lender looks for the amounts of money borrowed in the past, whether the loan payments were made on time, and how quickly the loan was repaid. Other factors figuring into your overall credit score are job stability, the state of the economy, income level, and income stability.
Credit bureaus keep track of all of this information, so lenders consult them for a credit report on you to determine your creditworthiness. This is usually expressed in the form of your credit score.
The major credit bureaus in the United States are FICO (formerly known as the Fair Isaac Corporation), Experian, TransUnion, and Equifax. While you can get a free credit report every 12 months at www.AnnualCreditReport.com, there is typically a charge of around $10 to learn what that report translates into in terms of an overall credit score. The FICO score ranges between 300 (bad credit) and 850 (pristine credit). Borrowers with good credit histories fall in the 700 range and above.
How Auto Loan Rates Are Calculated: Interest Rate Types
Interest rate types typically fall into one of two categories; Simple or Compound.
A Simple Interest Rate, as its name implies, is simply a percentage of the amount loaned added to the monthly payment. As an example, say you borrowed $120 and you agreed to pay it back over a 12-month period with an interest rate of 10 percent. This would make your monthly payment $11.20 and you would pay a total of $14.40 in interest for the loan. Thus, the total amount you’d pay for the loan is 134.40.
Applying Compound Interest to the scenario above, the 10 percent interest is calculated for the $120 total for the first month (120 + 12 =134) making the first payment (134/12 = $11.17). The 11.17 is then subtracted from the $134 leaving a remainder of $122.83. The interest rate of 10 percent is then added to that amount and the next payment is calculated based on the new total — every month.
Paying off a Compound Interest Loan is considerably more expensive, if offered a choice, always choose Simple Interest.
How Auto Loan Rates Are Calculated: Debt-to-Income Ratio
The lender of course wants to make sure the loan will be repaid. A good measure of your ability to repay a loan is how much money you already owe others, compared to how much income you generate each month. If you owe more than you make, giving you a loan probably isn’t such a good idea. However, if you make way more than you owe, odds are you’ll pay the loan back, so you’re considered a good risk.
The good news is you can calculate your debt to income ratio yourself.
Simply add up the total amount of all the bills you pay each month and divide that number by the amount of income you make each month. Let’s say you make $1000 each month and you have $300 in bills each month. 300/1000 = .3. This makes your debt to income ratio 30 percent. Typically anything below the mid 30 percent range is considered highly favorable, making you an acceptable risk.
How Auto Loan Rates Are Calculated: Down Payment
Another factor used to calculate auto loan rates is the down payment. The less risk the lender takes on, the better the ultimate interest rate they are usually willing to offer. By including a down payment, you are lessening the lender’s risk.
Simply put, a down payment is money offered to reduce the loan amount. In our scenario above, if you’re taking out a loan on something that costs $120 and offer a down payment of $40, the lender is now only risking $80 to help you make your purchase.
If your credit score is good and your debt to income ratio is reasonable, the $40 down payment entitles you to a lower interest rate than an identically situated person asking to borrow the full $120.
How Auto Loan Rates Are Calculated: Loan Term
The longer the term, the lower the monthly payment, the lower the interest payment. However, you’ll pay more because you’ll pay longer. Car loans usually run from 36 months to 72 months. If you need to go over 48 months to get the payment down to a number you can afford, you probably can’t afford that car. Avoid anything over 48 months.