Interest rates can sometimes make the difference between sealing a deal on the car of your dreams or settling for something less. But before you settle, consider the many options available for financing an auto loan.
Typically, locking in a fixed-rate loan is the best advice in a period of accelerating interest rates. But not all fixed-rate loans are created equal. If you’re a homeowner, for example, you might consider a home equity loan, which usually carries a lower interest rate than financing through a dealer, and for many individuals, the interest is tax deductible (consult a tax advisor about your particular situation).
Most auto loans are made with a fixed percentage rate that is linked to mostly short- and intermediate-term government securities called Treasury bills (T-bills). Recently, rates have been tracking the fluctuations in the three-year T-bill rate. Shorter-term rates typically adjust when the Federal Reserve either raises or lowers its interest rates. A rising rate increases monthly payments on cars, whereas falling rates have the opposite effect. Buyers should be aware that dealers that provide financial services usually mark up the cost of a loan beyond the rate of the lending institution.
You may get a better interest rate by applying for a loan before going car shopping. By pre-qualifying for a loan and locking in a fixed interest rate, you’re protected in the event that rates rise before you close a deal. You’re also in a better position to negotiate a lower rate from a dealership by having the option of financing directly through a lender.
Home equity loan
Let’s say you finance $20,000 on the purchase of a new car. The nationwide average rate on a home equity loan at the end of 2004 was 6.91 percent, whereas the average rate for a four-year new car loan was 7.51 percent. Using a home equity loan, a borrower would pay $268 less in interest payments over the course of the loan. Of course, your house would now serve as collateral for your car loan.
A fully deductible home equity loan would also deliver another $825 in tax savings over the four years to an individual in the 28 percent federal tax bracket (consult your tax advisor regarding the deductibility of interest). Use our calculator to determine if a home equity loan is a better choice for financing a car.
Although zero-percent financing is attractive on many new cars, buyers need to look at the trade-off if they are offered the choice of taking a rebate instead. The average incentive auto companies gave new car buyers grew to nearly $4,000 in 2004, according to CNW Marketing, which tracks the automotive industry. With this much of a rebate, you can come out ahead with independent financing.
If you were to buy a $20,000 car, for example, and take a $4,000 rebate, you’d have to borrow only $16,000 from an outside lender. At 7.51 percent (the average rate for new car loans as of December 2004), that would cost you $386.86 a month, for a total outlay over four years of $18,569.28 -- $1,430.72 less than the $20,000 total you’d have paid by foregoing the rebate and accepting the dealer’s offer of zero-percent financing.
Although harder to find, variable or adjustable-rate loans can help you save on interest payments, particularly in stable or declining interest rate environments. Adjustable loans normally offer lower interest rates than the usual five-year car loan. Variable auto loan rates are likely to be based on the prime lending rate, the benchmark banks use to determine interest on loans to their customers.
If rates are tumbling, consider refinancing your auto loan. Although the savings are not huge, the up-front fees generally average only about $15 to $25. A drop in interest rates from 7.5 percent to 5.5 percent on a $20,000, four-year loan will save you $18 a month, or $432 on the last two years of the loan.
You may also be able to lower your interest rate by improving your credit score. Consider paying credit cards down below 50 percent of the card’s limit. Also, canceling high-rate cards or replacing them with a home equity loan can improve your credit score and allow you more leverage to negotiate a lower rate from a lender.