UPDATED: April 6, 2022
Next to houses, cars can be one of the most expensive purchases you’ll make in your lifetime. So it pays to shop around and make sure you lock in the best possible interest rate if you’re financing the vehicle. But when the dealer tells you the rate, you may be wondering, what’s a good rate for a car loan anyway?
In this article, we’ll cover:
- How APR is determined on a car loan
- Prime vs. sub-prime loan spectrum
- How to get the best rates
- What is a reasonable rate for a car loan
Table of Contents
How is APR Determined?
The most significant factor determining how much you’ll pay over the life of a car loan is the Annual Percentage Rate (APR). This percentage is the amount of interest you’ll pay on the loan annually and fluctuates per borrower.
Not everyone who walks into a dealership to buy a car will receive the same loan terms or APR. The factors that determine whether your APR is going to be higher or lower are things like:
- Credit score: A higher credit score means you’re a more trustworthy borrower and banks tend to charge lower interest rates. Your credit score can affect the APR of the loan by up to 10%. If you have a low credit score, you can consider having someone co-sign the loan in an attempt to decrease the rate.
- Length of the loan: A shorter loan (less than 60 months or 5 years) generally has a lower interest rate. Since lenders can recoup their money faster, it’s viewed as less risky. A longer loan (72 months) carries more interest rate risk for the lender, so they pass that on with a slightly higher rate.
- Down payment: A larger down payment means overall you’re borrowing less money. If you can decrease the amount financed, its possible to have access to lower interest rates on the new, smaller loan.
- Vehicle selection: It may seem counter-intuitive, but the interest rates on used vehicles tend to be higher than those on new ones. This is because it’s much harder to estimate the value of a used car. And used cars are more likely to lose value quickly due to issues over time. So lenders charge higher interest to recoup some of the value if you default, and they need to sell the car at a loss.
The Spectrum of Prime and Sub-Prime Borrowers
Lenders classify borrowers in different categories based on risk. Those with higher credit scores are deemed less risky and tend to receive the most favorable rates, while those with lower scores are perceived as riskier and may see significantly higher interest rates.
The Consumer Financial Protection Bureau breaks down the risk profile of borrowers into the following 5 categories.
- Super prime: Borrowers with higher-than-average credit scores are considered the least risky of all. That means lenders are far more likely to entrust borrowers with a hefty loan at a low rate.
- Prime: Those with “good” credit are likely to be placed in the prime category where lenders feel the borrower is less risky and likely to pay back loans timely and in full.
- Near-prime: This credit score range is a step above sub-prime, with lenders likely to enforce slightly higher interest rates and less advantageous loan terms.
- Sub-prime: A “fair” credit score places you in a sub-prime territory where lenders feel a decent level of risk in extending a loan. Because of this, the APR will be significantly higher than on a super prime or prime loan, sometimes up to 10% more. Sub-prime borrowers may also be limited to working with sub-prime lenders that specialize in higher interest rates.
- Deep sub-prime: Those with “poor” credit may be viewed by lenders as too risky to loan. But if a lender does take the chance on a deep sub-prime borrower, interest rates of up to 15-20% may deter borrowers.
Source: Experian State of Automotive Finance Markets Q4 2020
How to Get the Best Interest Rate
When it comes to taking out an auto loan, no matter where you fall on the spectrum of credit scores, it’s essential to compare several different lenders. If you’re not happy with the rates you’re presented, you may want to consider:
- Improving your credit score: If you have a lower credit score, it might pay to take some time to improve your score. Your score may go up if you make bill and loan payments on time, keep your debt-to-income ratio low, and keep credit utilization low. It may take several months to see your score go up, but it could pay off dramatically over the life of your loan.
- Getting pre-approved: You can apply for pre-approval with multiple lenders before you even set foot in the dealership. As long as you have a ballpark idea of how much you might want to finance, you can at least get a feel for what’s available.
- Haggling if you can: Most shoppers will try to haggle down the price of a vehicle. But it’s important to recognize that you can sometimes negotiate on the interest rate, too, especially if you’re working with the dealer directly.
What’s a Good Rate for a Car Loan?
What’s considered a good rate for a car loan will vary based on your qualifications as a borrower. A 2-5% rate would be considered reasonable for someone with a prime or super-prime credit score. On the other hand, if your credit falls into the sub-prime range, you might feel good about getting a 10% rate on your loan.
The best rate for your car loan is one that you can afford. Any interest rate that means you won’t meet your monthly payment could end up being more damaging to your credit over the long term.
The Bottom Line
Many factors contribute to the rate you might get on a car loan, including your credit score and the loan length. Be sure to shop around, make a hefty down payment if you can, and always negotiate to get the best rate possible from your lender.
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