Understanding fixed rate vs. variable rate for auto loans
What are interest rates?
Let’s say you want to borrow $25,000 to buy a car. You go to the bank and ask for 25k. The bank checks your credit score, assesses your risk, and finally agrees to lend you the money. But they’re not going to give you the money for free.
Interest is the fee that you pay for borrowing someone else’s money. It works both ways. When you put money into a high yield savings account, for instance, the bank will pay you interest because your money is in their hands.
Interest is calculated based on a percentage of the total amount you owe. You don’t pay that fee all at once; it’s spread across the entire length of your term. Each month some of your car payment will go towards paying off the interest, and some will go to paying off the principal balance for the car. Because interest is calculated every month, the faster you pay off your loan the less interest you’ll have to pay.
So, an interest rate is the amount you pay each year in interest, expressed as a percentage of the whole. Interest rates go from 0% all the way up. Typically, loans for new cars have an interest rate of 6%, and used cars have an interest rate of 10%.
Interest rates vary based on all kinds of things, which is why it’s important to shop around to different lenders to find the best interest level. When you’re shopping around, you’ll want to understand variable vs. fixed interest rates so you can find a loan term that makes the most sense.
What are variable interest rates?
Each month, when your loan payment is calculated, the interest rate applied changes based on the bank's primary rate, which in March of 2023 was at 7.75%. If the primary rate is low, your variable interest rate will drop and your loan will become more affordable. But if the rate rises, your loan’s rate will increase to compensate for the increased risk of the company lending you money. A higher interest rate means your monthly payment is higher.
Let’s say you shop around and are able to get a 5% introductory variable rate, with 1% increases every six months until it is capped out at 11%. With a 25k loan, you’d end up with monthly payments ranging from 471$ to $543, and you’d pay $5,500 in interest during your 60 month term. If you wanted to pay it off in 36 months, you’d have payments of $749 to $818, but you’d only pay $2,182 in interest.
Why would you want a variable interest rate?
If you plan to pay the loan off very quickly, you may be able to find a loan with a low introductory rate. If the loan has a 1% interest rate for the first 12 months, you could pay the entire loan off and only pay a very small amount of interest.
Some variable interest rate loans have capped rates, meaning that the rate can only go so high. That might make the prospect of a variable loan less risky. Like in our example, if you know the rate will only get to 11%, you can anticipate your payment amounts.
What are fixed rates?
Fixed rates are rates that stay the same for the entire life of the loan. Banks and lenders use risk based pricing to calculate how much interest they need to charge on the loan. During the pandemic, interest rates were really low, and people who could act on that got loans with incredibly low fixed interest rates. That means that now, even though interest rates are rising, even though indexes may not be doing as well, those loans don’t see an increase in monthly payments. Their rate stays constant.
However, if you need to buy a car now when interest rates are high, you’ll be stuck with that high interest rate for the entire term of the loan, even if in six months interest rates go down again.
So let’s say you shop around, and are able to get a 6% interest rate on your $25,000 loan. Your monthly payments would be $471, but you’d pay, ultimately, $3,999 in interest over 60 months. If your term was 36 months, instead, your monthly payment would be $749, but you’d only pay roughly $2,379 in interest.
In our two examples, a variable interest rate from 5-11% meant you’d pay $2,182 in interest over 36 months. In a fixed rate situation, you’d pay $2,379 in interest because you started off with a slightly higher interest rate. But when you stretch the term out to 60 months, suddenly the variable interest rate will cost you $5,500 in interest whereas the fixed price rate would only cost you $3,399 in interest.
Why would you want a fixed interest rate?
If you know the loan will take you a long time to pay off–like a mortgage, or an expensive car with a long loan term, a fixed rate could save you thousands.
If you take advantage of a time period with low interest rates you might be more easily able to get a low fixed interest rate.
How do these affect your payments on a refinanced plan?
Variable vs. fixed interest rates can matter a lot. When you refinance your auto loan, your new lender pays off your old loan, and then you take out a new loan with the new lender to cover that amount. This process allows you to ditch high interest rates, excessive fees, and overly long payment terms. Renegotiation allows you to figure out better terms that work for you.
Unlike in our examples, in the real world your $25,000 car loan comes with extra things, like sales tax and fees. But with Rateworks, there are no fees. A $25,000 won’t mysteriously become a $28,000 loan; you know what you’re getting.
Talk to our team today to find out how you could refinance your auto loan and get better loan terms.