The answer to this question actually depends on who you ask. Below, we explain how interest rates are determined from the perspective of the lenders that make credit decisions on a borrower-by-borrower basis. We’ll also take a look from a macroeconomic perspective that takes into account market forces that influence consumer lending rates in the broader economy.
How are Interest Rates Determined for Car Loans?
How are interest rates determined: the lender perspective
The logic behind interest rate calculations is pretty straightforward, and it generally boils down to perceived risk. When a lender gives you money in the form of a loan, they’re essentially betting that you’ll pay that money back. If it is a good bet that you’ll pay the money back, lenders are generally willing to accept a smaller rate on the loan. If, on the other hand, the lender believes that there is a relatively good chance that you won’t pay the loan back, they’ll want to charge a higher rate as compensation for accepting the increased risk associated with you as a borrower.
This underlying risk/reward logic isn’t just a factor in lending. It’s actually an important influence in economic systems and consumer decision-making - impacting everything from financial markets to international relations.
So how do lenders determine how much risk they should associate with a given borrower? In most cases, potential factors that lenders evaluate in determining an interest rate for a given borrower include:
- Credit score: A credit score is a numeric representation of a borrower’s creditworthiness determined by a number of factors, including payment and default history on revolving debt obligations; history of collections, liens, or judgments; ratio of revolving debt to credit available; and recent credit activity.1
- Loan to Value (LTV) ratio: The amount you’re borrowing divided by the value of the vehicle you’re purchasing. The lower this ratio, the less risk the lender is accepting, so providing a down payment to reduce the LTV of the loan can reduce the rate you’re charged by the lender.
- Loan amount: In some cases, different loan amounts are associated with different levels of risk.
- Debt ratio: The ratio of your monthly payment obligations (generally only revolving debt obligations) to your monthly income. Financing a vehicle will increase your monthly payment obligations, so the lender will want to make sure that your debt ratio will remain at an acceptable level after including the vehicle payment.
How are interest rates determined: the macroeconomic perspective
At the beginning of the article we stated that the answer to how interest rates are determined depends on who you ask - so, other than lenders, who else could we ask? Many economists study consumer lending rates, and most will tell you that, in addition to the micro-story about how rates are determined, there are a number of macroeconomic factors at work that move consumer lending rates in one direction or another.
At a macroeconomic level, one of the most important factors in determining interest rates in automotive lending is the cost of funds2 to the lenders themselves - or, in other words, the amount they’re paying for the money they intend to lend to consumers. Automotive lenders aren’t necessarily banks or money houses with spare cash lying around that they lend to consumers. In many cases, they’re actually intermediaries that buy money in credit markets3 by selling bonds or other financial instruments and then lending the proceeds of these sales to consumers. Their business model is to profit on the margin between the rate they’re paying to borrow the money and the rate they’re charging consumers. The rates they charge consumers fluctuate on the basis of the rates they pay, and the rates they pay depend on the amount of capital available on these credit markets.
So what determines the availability of, and demand for, capital in credit markets? Broadly speaking, both the supply of capital available in credit markets and the demand for the available capital are a reflection of economic activity. In general, when the economy is doing well, various actors in the economy (individuals, corporations, banks, etc.) earn more money than they intend to spend, and rather than leave their spare cash in a bank account, they invest it in financial instruments likely to yield a return. Some of it makes its way into credit markets, increasing the supply of credit available and driving consumer lending rates down.4
The other half of the story is the demand for this capital. When the economy is doing well, people buy more merchandise, including cars. When demand for consumer goods increases, demand for credit increases, and consumer lending rates increase as a result. So in macroeconomic terms, the rates consumers are charged for automotive loans are the result of a balancing of credit market factors.5
What does all of this macroeconomic theory mean for the average borrower? Through 2014 and 2015, not a lot. Average new car loan rates for prime borrowers increased from 3.61% to 3.67% from Q1 2014 to Q1 2015.6 New car loan rates increased from 10.79% to 10.96% for subprime borrowers over the same period. In the near term, auto lending rates appear stable - probably an indication that, for the time being, credit supply and demand are near equilibrium.