When it comes to buying a car, most people will need to finance the purchase with an auto loan. But with so many different loan options available, it can be difficult to know which one is right for you.
One of the key decisions you’ll need to make when getting an auto loan is whether to choose a fixed or variable interest rate. Understanding the differences between these two types of rates is crucial to finding the loan that best fits your budget and financial goals.
In this article, we’ll take a closer look at fixed and variable rates for auto loans, including the pros and cons of each and how to choose the right option for your needs.
What is Fixed Rate Auto Loan?
A fixed rate auto loan is a type of car loan where the interest rate is set at a fixed rate for the entire term of the loan. This means that the interest rate will not change, regardless of changes in the market or the lender’s policies.
Additionally, a fixed rate loan means the interest rate will remain constant throughout the life of the loan regardless of market conditions or other factors. This makes budgeting easier since you know exactly how much each payment will cost every month until all payments have been made in full.
How Does Fixed Rated Auto Loan Work?
Fixed rate auto loans are typically offered by banks, credit unions, and other lending institutions. The interest rate for these loans may vary based on the borrower’s credit score, income, and other factors. However, once the interest rate is set, it will not change over the life of the loan.
With a fixed rate auto loan, borrowers can expect to have the same monthly payment amount throughout the entire loan term. This can be beneficial for those who prefer to have a predictable and stable payment plan. Borrowers can also budget for their car payments with more accuracy since they will know exactly how much they will need to pay each month.
The downside is that if current market rates drop during this time period, then borrowers with a fixed-rate won’t benefit from those lower rates unless they refinance their existing loan at some point down the road (which may not always make sense).
What is a Variable Rate Auto Loan?
A variable rate auto loan is a type of car loan where the interest rate can fluctuate over the life of the loan. The interest rate on a variable rate auto loan is typically tied to an index, such as the prime rate, and can change based on changes in the market or the lender’s policies.
Your monthly payments with a variable rate vehicle loan, also known as an adjustable-rate mortgage (ARM), may alter over time depending on what occurs with general market interest rates, such as those on Treasury bills or the LIBOR index funds that lenders use to determine ARM terms and rates.
Your APR will change if these underlying indices rise or fall, but only to the extent specified in the contract language between the lender and borrower before concluding any relevant agreement(s).
Nonetheless, in general, ARMs have higher initial APRs than equivalent FRAs since banks take on greater risk with them due to potential volatility, needing more compensation through higher pricing structures initially offered to clients who choose to utilize such products instead.
How Does Variable Rate Auto Loan Work?
A variable rate auto loan works by having an interest rate that can change over time based on market conditions or the lender’s policies. The interest rate for a variable rate auto loan is typically tied to an index, such as the prime rate or the London Interbank Offered Rate (LIBOR). The lender will add a margin on top of this index rate to determine the final interest rate for the loan.
When the index rate changes, the interest rate on the variable rate auto loan will also change. For example, if the prime rate goes up, the interest rate on the loan will also go up. Conversely, if the prime rate goes down, the interest rate on the loan will also go down.
Most variable rate auto loans have a maximum interest rate, or “ceiling,” which is the highest interest rate that the borrower can be charged. This provides some protection for borrowers in the event that interest rates rise significantly.
The frequency of rate changes may vary based on the terms of the loan. Some loans may have a set rate adjustment period, such as every six months, while others may adjust the rate on a monthly basis.
Pros and Cons: Fixed Rated Auto Loan vs. Variable Rate Auto Loan
Here are some pros and cons of fixed rate auto loans and variable rate auto loans:
Fixed Rate Auto Loan
- Predictable monthly payments: Since the interest rate on a fixed rate auto loan does not change over the life of the loan, borrowers can expect to have the same monthly payment amount throughout the entire term of the loan.
- Budgeting made easy: With a fixed rate auto loan, borrowers can budget for their car payments with more accuracy since they will know exactly how much they will need to pay each month.
- Protection against rate hikes: Borrowers with a fixed rate auto loan are protected from interest rate increases, as their rate will not change.
- Higher interest rates: Fixed rate auto loans may have higher interest rates than variable rate loans, especially if interest rates in the market drop after the loan has been issued.
- No benefit from rate drops: Borrowers with a fixed rate auto loan will not benefit from any decreases in the market interest rates.
Variable Rate Auto Loan
- Lower initial interest rates: Variable rate auto loans may initially have lower interest rates than fixed rate loans, which can make them more affordable in the short term.
- Potential for rate drops: Borrowers with a variable rate auto loan may benefit from any decreases in the market interest rates, resulting in lower monthly payments.
- Flexibility: Variable rate auto loans may offer more flexibility, as they may allow borrowers to make extra payments or to pay off the loan early without incurring penalties.
- Unpredictable monthly payments: The interest rate on a variable rate auto loan can change over time, resulting in fluctuations in the monthly payment amount.
- Higher risk: Borrowers with a variable rate auto loan are at risk of higher monthly payments if interest rates in the market rise.
- Uncertainty: The borrower’s monthly payment amount and overall cost of the loan cannot be predicted with certainty, as it is dependent on market conditions.
Overall, choosing between a fixed rate auto loan and a variable rate auto loan will depend on the borrower’s individual financial situation and risk tolerance. It’s important for borrowers to carefully consider the pros and cons of each type of loan and to choose the one that best fits their needs.
Whether a fixed or variable rate vehicle loan should be taken out fully depends on personal circumstances, such as credit score history, desired length of repayment term, as well as preferences regarding stability vs. flexibility given through both options accessible in today’s market.
In the end, though, regardless of the path taken, best practice recommends conducting study beforehand and choosing the alternative that best fits your needs while taking advantage of the lowest prices attainable along the same!
Q: Can I switch from a fixed rate auto loan to a variable rate auto loan?
A: It may be possible to refinance your fixed rate auto loan to a variable rate auto loan, but it’s important to carefully consider the pros and cons and to ensure that the new loan is a good fit for your financial situation.
Q: Are there any fees associated with changing from a fixed rate auto loan to a variable rate auto loan?
A: Refinancing a loan may come with fees, such as application fees, appraisal fees, and closing costs. It’s important to carefully review the terms of any loan before agreeing to it.
Q: Can the interest rate on a variable rate auto loan go up infinitely?
A: Most variable rate auto loans have a maximum interest rate, or “ceiling,” which is the highest interest rate that the borrower can be charged. This provides some protection for borrowers in the event that interest rates rise significantly.