Lenders take a risk with each loan they provide. The greater the risk the borrower represents, the higher the interest rate that borrower can expect to pay. The best-case scenario is a 0% interest rate. But, as the saying goes, 0% rates are for zero-risk borrowers. At the end of the day, interest is the premium paid for the privilege of borrowing money.
We'll walk you through all the factors that affect your interest rate, so you know exactly what to expect-before arriving at the dealership. But before we do that, there's one final caveat worth covering.
How the Bank of Canada affects your interest rate
Modern monetary policy is the effort of nation-states (or, in the case of the European Union, multinational organizations) to maintain currency stability. This is achieved by balancing the need to encourage economic growth while also limiting inflation.
The Governing Council of the Bank of Canada sets an overnight rate for lending, also called the Key Interest Rate, that establishes the daily (overnight) lending rate between financial institutions. Since 1991, this rate has had an inflation control target of 13%. This target is renewed every five years by the federal government.
Most economists agree that 2% inflation reflects an appropriate balance to encourage economic growth while avoiding damaging inflation. As the economy “heats up” and inflation increases, the Bank of Canada may raise interest rates to make borrowing money more expensive, thereby slowing the economy and stemming inflation.
During times of weak economic growth, the Bank can cut interest rates to make borrowing money cheaper, thereby incentivizing lenders and borrowers to lend and borrow more money. As of October 2016, the overnight rate was 0.50%, the lowest in Canadian history. Rates increased slightly to 1.25% as of January 2018. They peaked at 21% in the early 1980s.
Why does this matter? Because the Key Interest Rate sets the stage for individual lenders. The less it costs lenders to borrow, the less they can profitably charge individual borrowers for auto loans, home mortgages, or other loan products.
So while your personal credit history affects where along the interest-rate spectrum you'll land, the Bank of Canada-guided by national and international economic factors-determines the far ends of the spectrum.
The four factors that affect your interest rate
Remember that your interest rate does not include all non-principal payments on an auto loan, which may also include document preparation fees, title fees, filing fees, and warranty charges. The more complete figure is the annual percentage rate (APR). The APR includes all finance charges associated with your loan, expressed as an annual rate.
As you apply for a loan or visit a dealership, ask for the APR-rather than just the interest rate-to gain a complete understanding of all out-of-pocket expenses.
1. Credit history
Your credit history is more than just your credit score. This is a fact we bring up time and again to clients. That said, the purpose of your credit score is to provide lenders with a number that reflects your credit history and serves as a reasonable predictor of your future credit worthiness. Credit scores, which range from 300 to 900, are determined by two major credit-reporting agencies: Equifax and TransUnion.
Credit scores are based primarily on a borrower's debt-to-income ratio and bill-payment history. Your credit score also takes into account other credit events, including charge-offs, judgments, or collections. There's a strong correlation between your credit score and the interest rate you can expect to pay for an auto loan. A higher score means a lower rate. Zero-percent interest rates are reserved for those with the highest credit score, 700 and higher.
Slightly higher rates are available to those with mid-range scores in the 600s. A credit score below 500 likely means higher interest rates and may negatively impact your ability to get approved for a loan. Borrowers emerging from bankruptcy start with the lowest possible credit score.
Some potential borrowers with a low credit score may benefit from a cosigner on their loan. A cosigner is a person with a higher credit score, perhaps a family member or close friend, who agrees to take responsibility for your loan if you default. This added security for the lender can result in lower interest rates for the borrower and help with approval.
If you're looking for other ways to improve your credit score and lower your interest rate, take a look at your credit mix. Most lenders like to see a blend of revolving (e.g. credit card) and installment (e.g. mortgage, student loan) credit. Repayment of past loans certainly works in your favor, but lenders focus on the potential risk of lending to you in this very moment, which is why active, up-to-date credit accounts can help you secure a lower interest rate.
2. Loan term
In general, most auto loans longer than 60 months carry an increased interest rate. This is because a longer loan term represents greater risk to the lender, who must depend on your credit worthiness and repayment over a longer period of time.
A shorter loan term-even if the interest rate stays constant-means less total money dedicated to interest payments. However, shorter loan terms also divide principal payments by fewer months (36 instead of 72, for example). This means higher monthly payments. It's a sound financial strategy, but only if you can afford it.
In short, if you want the lowest possible interest rate, choose a shorter loan term. Just know that your monthly payments will be higher, even though you'll save money in the long run.
3. Down payment
Having a down payment is an easy way to lower your interest rate. Why does it lower your interest rate? Because a lender is lending less money, decreasing their risk. But there's another reason, too. A down payment shows a lender that you're serious about your commitment to repay your loan and that you had the forethought and discipline to save money for a down payment.
A cash down payment isn't absolutely necessary-the trade-in value of your existing vehicle, if you have one, may suffice as a down payment-but any down payment puts you in a better position to receive a more favorable interest rate. (At the very least, it reduces the amount you owe, making your monthly payments smaller simply because the principal of the loan decreases.)
4. Other financial factors
Not all financial variables are accounted for in your credit history, loan duration, and down payment. Quality lenders take other factors into consideration that may affect your interest rate.
One influence is your current job status. Most lenders like to see someone with a steady employment history of at least two years. Stability is important because a lender must project your credit worthiness now and several years into the future. (Be prepared to provide evidence, such as recent pay stubs, to verify your employment. Your lender may call your employer as well.)
If you feel that your work history is a bit unstable, or you're just starting out in your career, providing a larger down payment may offset the impact of a limited work history, helping you secure a lower interest rate. Similarly, finding a vehicle that doesn't strain your budget may make a lender more confident and lead to a lower interest rate.
The impact of your income is balanced by existing debt and regular monthly expenses. The amount of your paycheck is less important than the relationship between your paycheck and your expenses. Plenty of borrowers making good money spend too much, and plenty of frugal borrowers have sound finances despite modest incomes.
Another factor unique to car buying is the added incentive for on-site auto loan providers to find a solution that works for you. Unlike banks, dealerships are motivated to sell a car and benefit by finding a financing option with an interest rate that works for your budget.
The interest rate a lender offers takes a number of factors into consideration, which makes it impossible to provide a simple, accurate interest rate calculator.
And while you may not want to wait until you apply for financing to find out what interest rate you'll pay, you should also be glad for this flexibility-a multitude of variables means that, if you fall short on one, you have the opportunity to compensate with another part of your financial picture.
So take the first step. Fill out our quick online application to find out what interest you can expect to pay.
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