What Does the Interest Rate on a Car Mean?

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Car loans are generally assigned a rate of interest.
Car loans are generally assigned a rate of interest. (Image: yellow car, a Honda Japanese sport car model image by alma_sacra from Fotolia.com)

Many cars, particularly new ones, which can command a price in the tens of thousands of dollars, are purchased not with cash but with the aid of a loan. The borrower purchasing the car usually repays the loan in monthly installments, to which the lender will add a preset rate of interest.

Features

Loans to purchase vehicles are generally offered either by the company selling the car or from another financial institution, such as a bank or credit union. Like a mortgage or business loan, the issuer of the loan will put up the cost of the purchase, receiving compensation in the form of interest on the loan.

Types

Auto loans vary according to the length of loan and the rate of interest. According to BankRate.com, a typical car loan will last between 24 and 60 months, some dealers will offer loans that last up to 84 months. However, longer loans generally command a higher rate of interest. Interest rates on loans are either fixed-rate loans or adjustable rate loans, which adjust over time, correlated to the prevailing interest rates. In some cases, the interest on the loan is compounded; in other cases, it is not.

Significance

Even a small difference in the interest rate of a car loan can mean the difference between thousands of dollars over the life of the loan. According to BCS Alliance, a difference of 1.55 percent on the interest rate for a 60-month loan for a $20,000 car works out to a difference of almost $1,000.

Expert Insight

According to BankRate.com, new cars generally receive lower rates of interest than used cars and also receive longer lengths for their loans. This can mean a buyer can actually end up paying more for a used car with a lower sticker price than for a new car with a higher price because the buyer is paying more on interest. With most loans, however, the borrower will spend a period of time early in the loan "underwater," meaning the borrower owes more on the car than it is currently worth.

Warning

If the payments on the car become unaffordable -- which can happen due to a change in the borrower's financial situation or, in the case of an adjustable rate loan, a spike in interest rates -- and a borrower begins to miss payments, he may be at risk of losing the car. If the loan becomes delinquent, the issuer may repossess the car; generally, he will not be required to refund any money that the borrower has paid on the loan.

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