If you’ve ever purchased a vehicle, you probably know that you can spend almost as much time shopping for rates as you do picking out your new car. But what if I told you that you didn’t have to spend so much time finding the best interest rate?
Yes, sometimes getting the lowest interest rate is extremely beneficial when it comes to your car payments. A difference of a couple of percentage points—0.9% compared to a rate of 3.9%, for example—can lead to huge monetary savings on your auto loan in the end, particularly on a higher-cost vehicle.
However, oftentimes, focusing on the interest rate does more harm than good.
THE MOST IMPORTANT FACTORS WHEN BUYING A CAR
When it comes to car buying, the truly important factors to consider are:
- The type of car: are its features appropriate for you and your lifestyle?
- The cost: is it affordable?
- The lender: what level of service will you receive?
You’ll notice interest rate didn’t make the list. That’s because the interest rate shouldn’t dictate your car-buying experience. In fact, it should be one of the last factors you consider when car shopping. In the end, the difference may be a quarter of a point (0.25%) or less, which rarely means great savings over the course of a loan.
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HOW DO INTEREST RATES WORK, AGAIN?
Before we go further into why interest rate shopping can be detrimental to car buying, let’s refresh our memories about how interest rates work and why a lower interest rate may not save you as much as you think.
Whether it’s your auto loan, mortgage, or other lending arrangement, your interest rate is amortized every month. This means that while you pay the same amount each month, a portion goes towards your interest while the rest goes toward your principle (the amount of your loan). The amount of interest you pay off each month is calculated by dividing your annual interest rate by 12 (your monthly interest rate) and multiplying it by your principle. Over time, as you pay off your principle, your interest payments grow smaller and the amount that goes toward your principle becomes larger.
Let’s use some actual numbers in an amortization table to illustrate how this works using a $20,000 loan with a 60-month term and a 5% interest rate.
|Month||Starting Balance||Monthly Payment||Monthly Interest Paid||Principal Paid||Balance||Total Interest Paid|
But what if you found an interest rate for 4.9%? How much would you save?
At the end of your five-year loan, you’d save a total of $54.94. That’s $10 a year!
(If you’re interested in further exploring how your interest rate might impact your specific car payment and how much car you can afford, check out our financial calculator to see how your interest rate factors in with your monthly budget, down payment, trade-in value, and loan term.)
Ultimately, the lender that gives you the rate is more important than the rate itself. And for what little you save on rates—the equivalent of a couple of lattes each year—you could pay the price in service from your lender.
THREE TYPES OF LENDERS & THEIR PROS AND CONS
Generally speaking, there are three types of lenders you can choose to work with on your auto loan. We’ll cover what you can expect from each and the pros and cons of choosing one over another.
- Local lenders
- Larger lenders
- Captive financiers
There are four main benefits from working with a local lender for your auto loan:
- More time and attention. With a local focus and smaller base, your neighborhood credit union or bank can give you the time and attention you need.
- Personalized service. Your local lender will treat you like a human being, not a faceless loan application. They’ll get to know you beyond your credit score to see you as a whole person—your family, your goals, your dreams—to serve your individual needs.
- Invested in the community. They’re not just invested in the community; they’re part of it. You’ll work with a person who sees you as part of it, too, and wants to support you as a community member and neighbor. A rising tide lifts all boats.
- Partnership over profits. Your local lender will keep in touch and find creative ways to work through any payment issues you may have. Your loan agreement isn’t a transaction. It’s a collaboration. You and your lender will work together to make it work.
As a smaller institution, your local credit union or bank may give you a slightly higher rate than larger lenders or captive financiers. However, the small amount you’ll pay over the course of your loan more than pays for itself by giving you a better overall experience.
Large financial institutions like Bank of America or Citibank have the benefit of being able to offer slightly better rates because of their size. But a better rate doesn’t mean a better experience.
Big banks can be difficult to work with for a couple of reasons:
- Impersonal service. Oftentimes, their lending department is mostly an automated phone experience that never gets you through to a real person. If or when you do eventually reach a live human being, they are less likely to know you personally, outside of what they can see in your file.
- Indifferent service. If you are working with a dedicated person, odds are you’re one of many clients they’re attempting to serve. They may not be able to provide the level of service that accounts for your circumstances or attends to your individual needs.
Captive financiers are lenders that are associated with a car company, like Honda or Ford Motors, to finance that particular brand of vehicles.
Like larger lenders, captive financiers can often offer lower rates. They can offer better rates for two reasons:
- They are typically a larger corporation with more assets than your local financial institution.
- They are subsidized by their associated car brand to cover the cost of a lower rate, which Honda or Ford does to incentivize consumers to purchase their line of cars.
Captive financiers can be a great option when you can combine their lower rates with rebates offered by the dealership. Adding cash back from the car dealer on top of what you’ll save on interest can be the best option for maximizing your financial savings.
As a variation of a large lender, however, they also don’t typically provide the high level of personalized service you’ll find at your local credit union or bank. You’ll work with a regional team covering all of New England or the entire northeast, who may or may not get to know you over the course of your loan. You won’t be able to simply walk into your local branch and have an in-person conversation with your lender about your auto loan and how it impacts the rest of your financial goals.
THE BOTTOM LINE
Unless there’s a significant difference in annual percentage rate and how much you can save, the interest rate on your car payment is one of the less important factors when buying an automobile. Instead of rate shopping, focus on car shopping—which vehicle has the features (and price) on your checklist—and the lender behind the rate. When it comes to your needs and dreams, the small amount you’ll save might not make a big difference, but the lender you work with for the next few years can.
In the end, the higher level of service that comes with a slightly higher interest rate could be $50 well spent
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