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How The Economy Impacts Car Loan Interest Rates

How The Economy Impacts Car Loan Interest Rates

The cost of borrowing money to buy a car is influenced by a variety of economic factors. Interest rates on auto loans can fluctuate up or down depending on the current state of the economy. Understanding what drives these changes is key for consumers aiming to secure the most favorable financing terms.


This article will examine how three primary economic forces – inflation, federal interest rates, and supply and demand – directly impact car loan interest rates. By tracking these indicators and timing financing decisions accordingly, buyers can gain better control amid the peaks and valleys of the ever-shifting lending landscape.


Whether aiming to purchase a new or used vehicle, it’s wise for borrowers to comprehend the macroeconomic variables affecting interest rates. Being an informed shopper allows car buyers to find financing that aligns with both their budget and the prevailing economic climate.

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What Drives Interest Rate Changes

Interest rates on auto loans can fluctuate for a variety of economic reasons. Here are some of the key factors that impact movements in car loan rates:

 

Inflation Rates

As the prices for goods and services rise with inflation, lenders adjust their interest rates accordingly. High inflation leads to hikes in interest rates to help offset the decreased purchasing power of the dollar. When inflation is low and stable, rates tend to be lower.

 

Bank Of Canada Policies

The Bank Of Canada directly influences interest rates through its monetary policies. For example, the Bank Of Canada may raise its federal funds rate to combat inflation. This ripples through the economy, causing banks and other lenders to raise their rates on products like car loans.

 

Bond Market Yields

Lenders base their interest rates partly on the yields available on government treasury bonds. When bond yields rise, lenders can get higher returns, allowing them to offer lower interest rates. Dropping bond yields lead to higher borrowing costs.

 

Unemployment Levels

High unemployment makes lenders more cautious, as large numbers of unemployed consumers are seen as higher credit risks. To offset this risk, lenders charge higher interest rates on loans when unemployment is up.

 

Consumer Spending and Borrowing

Lenders view increased consumer borrowing as a sign of economic growth and confidence. More spending and credit use means they can relax rates to encourage further economic expansion. Less borrowing signifies potential downturns, leading lenders to raise rates.

 

Federal Interest Rates and Car Loans

One of the most influential factors on auto loan interest rates is the federal funds rate set by the Bank Of Canada. The Bank Of Canada raises or lowers this benchmark interest rate in order to manage economic growth and curb inflation.

When inflation starts rising rapidly, the Bank Of Canada will often raise interest rates to slow down borrowing and spending. Higher interest rates make it more expensive for banks and credit unions to borrow money, and those increased costs then get passed onto consumers through higher annual percentage rates (APRs) on loans and credit cards.

So when the Bank Of Canada raises its federal funds rate, interest rates across the economy also rise in tandem. This includes the prime rate, which is the rate banks extend to their most creditworthy customers. Most variable rate car loans are indexed to the prime rate, so the APR on those auto financing deals will move up when the prime rate increases.

In effect, Bank Of Canada interest rate hikes cool down consumer and business borrowing and spending. Less demand helps control inflation. But for car buyers, it means financing a new vehicle will cost more in interest following a Bank Of Canada rate increase.

 

Inflation’s Impact on Auto Financing

Inflation is one of the key economic factors that directly influences car loan interest rates. As the cost of goods and services rises over time, lenders adjust their rates to maintain profits. When inflation is high, auto financing companies will typically implement steep hikes in interest rates to counteract the decrease in the value of money.

For example, if inflation is 3% annually, a lender may raise rates by 0.5% to offset the reduced purchasing power of the loan’s value. This ensures they receive the same real rate of return despite currency depreciation. On a $20,000 auto loan, a 0.5% increase means paying $100 more in annual interest at a 5% rate.

Consumers with fixed interest rate loans are protected from incremental rate increases over the life of the loan. The interest rate remains locked in at the outset, even as lenders adjust for inflation. This provides stability in monthly payments. Variable rate loans, however, fluctuate as inflation rises based on indexes like the prime rate.

Under high inflation, fixed rates end up being lower than variable rates over the long run. However, if inflation falls, borrowers with variable rate loans can benefit from corresponding decreases in their interest rate.

 

Unemployment Levels and Consumer Borrowing

Economic factors like unemployment and consumer borrowing patterns also influence car loan interest rates. When unemployment levels are high, lenders view borrowers as higher credit risks. This poor economic outlook causes lenders to increase rates on all types of loans, including auto financing.

On the flip side, when consumer borrowing and spending levels are up, it signals positive economic growth. More spending and borrowing by consumers gives lenders confidence that loans will be repaid. That allows lenders to offer more competitive, lower interest rates to borrowers.

So periods of low unemployment and robust consumer borrowing activity tend to bring down car loan interest rates. But high unemployment makes lenders skittish, leading to across-the-board increases in financing costs.

 

Finding the Best Car Loan Rates

With interest rates fluctuating based on economic factors, it’s important for car buyers to shop around and find the best possible financing terms. There are several key strategies to secure a low-interest auto loan even when rates are on the rise.

 

Compare Fixed vs. Variable Interest Rates

One of the most important choices is deciding between a fixed or variable interest rate. Fixed rates remain the same over the life of the loan, while variable rates can go up or down based on indexes like the prime rate. When the economy is strong and rates are low, variable loans may offer better terms. But when rates are climbing, fixed rates provide stability and predictability.

 

Check Rates Frequently as the Market Shifts

Auto loan rates can change daily, so it pays to check frequently when shopping for a car. Even a small rate increase of 1% can substantially impact monthly payments. Monitoring Fed announcements and inflation reports provides insight into whether rates will rise or fall in the near future.

 

Improve Your Credit Score

Buyers with excellent credit in the 750+ range will qualify for the lowest rates. Improving your score by paying down debts and correcting errors can lead to lower interest rates. Even a small score bump can make a difference in rate quotes from lenders.

 

Consider Down Payment Amount and Loan Term Length

Putting more money down and choosing a shorter loan term reduces the amount financed and interest paid over the life of the loan. Opting for a 20% down payment and 36-month term will result in better rates than a longer 60-month loan with little down payment. Crunching the numbers helps optimize both monthly payments and interest costs.

 

Tracking Economic Indicators

Keeping tabs on key economic measures can empower car shoppers to secure the most favorable interest rates, even as fluctuations occur. Monitoring certain indicators gives consumers insight into whether rates are trending up or down. Being aware of where rates are heading means buyers can find the best deals when timing their auto financing.

Inflation is one of the most telling indicators for rate trends. The Consumer Price Index reports on inflation monthly, showing whether prices for consumer goods are rising or falling. When inflation goes up, interest rates tend to follow. Checking the CPI reports helps anticipate rate hikes.

Watching the Bank Of Canada’s monetary policy meeting announcements is another way to predict rate changes. The Fed directly controls short-term interest rates and provides guidance on their plans to raise, lower, or hold rates steady. Following Fed statements clues borrowers in on imminent rate shifts.

The monthly unemployment rate is a useful economic benchmark as well. High jobless levels often spur lenders to increase rates to account for greater perceived credit risk. However, lower unemployment signals economic strength, leading to more competitive lending rates. Tracking unemployment data can foreshadow rate trends.

Monitoring consumer credit statistics, like revolving debt and credit card delinquencies, gives further economic insight. More consumer borrowing and spending typically allows lenders to reduce rates and offer cheaper financing, as it indicates robust economic conditions. Analyzing consumer credit patterns helps time financing.

While no one can predict exactly when fluctuations will occur, routinely checking key indicators allows borrowers to forecast rate movements and find advantageous auto loan rates amid the ups and downs.

 

Comparing Lenders and Loan Terms

One of the best ways to find competitive auto loan rates is to compare multiple lender quotes. Rates can vary significantly from one financial institution to another based on factors like their current liquidity and lending goals. Taking the time to get pre-approved from several banks and credit unions is advisable for securing the most favorable interest rate.

When comparing lenders, pay attention to both the APR quote and any associated fees. An attractive headline rate could end up costing more overall if the lender tacks on large origination or prepayment penalties. Weigh the true total cost when choosing between lender offers.

The loan term length also merits close consideration. Longer loans of 72-84 months have lower monthly payments but accrue more interest over the full repayment period. Shorter terms of 24-36 months cost more per month but have lower APRs and total interest costs. Evaluate your budget and financial goals to pick the optimal loan duration.

Aim for the shortest term length you can reasonably afford. Going with a 60-month loan instead of 72 months could potentially save thousands of dollars in interest charges. However, a loan lasting 48 months that stretches your budget could end up being unaffordable, risking missed payments and credit damage.

Carefully balancing loan term length with monthly payment size and interest rate can help consumers land the best auto financing package. Avoid simply defaulting to the longest term, but instead shop around for the right loan structure matched to your financial capabilities.

 

Managing Variable Rate Loans

One of the risks of variable rate auto loans is that the interest rate can fluctuate up or down with the prime rate. When the Bank Of Canada raises the federal funds rate, the prime rate that lenders use to set variable rate loans will follow suit. This exposes borrowers to the potential for increasing interest costs over the life of the loan as economic conditions change.

One way borrowers can take control over a variable rate loan is to make extra payments towards the principal when rates increase. Making an extra monthly payment or paying a lump sum when possible essentially pays down the balance faster. This reduces the overall amount of interest owed over the remainder of the term. Prepaying principal ahead of schedule can offset higher rates to keep the total repayment amount in check.

Setting up automatic payments for an amount above the minimum due is an easy way to build extra payments into the budget. Rounding up to the nearest $50 or $100 gives borrowers flexibility to pay more without overextending their cash flow. Being proactive with extra principal payments allows borrowers to counteract rising rates on variable loans.

 

Refinancing an Auto Loan

One way borrowers can take advantage of lower interest rates is by refinancing their existing auto loan. Refinancing involves taking out a new loan to pay off your current auto loan. This allows you to potentially qualify for improved terms based on the current economic conditions.

Refinancing an auto loan makes the most sense if you can lower your interest rate by 1.5% or more. This amount of savings will help offset the costs of refinancing, such as application fees, title transfers, and more. You’ll also restart the clock on your loan term when you refinance.

To determine if refinancing could benefit you, get a current snapshot of your credit score and shop around to see what terms lenders are offering. Online lenders now make it easy to compare refinancing rates from multiple companies.

While securing a lower interest rate is the primary motivation for refinancing, you may also want to adjust your monthly payment. Refinancing can help you reduce your payment if you extend your loan term. Just keep in mind you’ll pay more interest over the life of the longer loan.

Refinancing can provide big savings over time, especially if you shave multiple percentage points off your interest rate. But be sure to weigh the costs versus benefits and shop around for the best overall deal before moving forward.

 

Alternative Financing Options

In addition to traditional auto loans from banks and credit unions, car buyers have a few other options for financing a vehicle purchase:

 

Peer-to-Peer Lending

Peer-to-peer lending connects individual investors with borrowers looking for loans. Sites like LendingClub and Prosper allow borrowers to apply for financing, then investors choose which loans to fund. Interest rates may be slightly lower than traditional lenders and credit score requirements can be more flexible.

 

Manufacturer Financing

Many automakers offer promotional financing deals to move inventory. This manufacturer financing often provides very low APRs for certain models. Rates and terms vary by brand, so it helps to compare offers. These loans are still administered through partner banks.

 

Buying Outright

For buyers with the cash, paying the full purchase price upfront avoids financing charges. This allows car shoppers to take advantage of any dealer discounts being offered. While not taking on debt is ideal, it requires having enough savings to pay the whole amount at once.

By looking beyond just banks for a car loan, buyers may find more favorable rates or alternative options to fit their budget and financial situation. Seeking multiple quotes leads to a better understanding of the financing landscape.

 

Impact of Credit Score on Rates

Your credit score is one of the biggest factors that determines the interest rate you’ll receive on an auto loan. Lenders view borrowers with higher credit scores as lower risk, since their strong credit history demonstrates responsibility with managing debt and making timely payments.

In most cases, you’ll need a credit score of at least 650 to qualify for a car loan at all. But the higher your score, the better the rate you’ll be offered by lenders. For example, someone with a credit score of 750 may receive an APR of 4% on their auto financing, while a borrower with a score of 650 would see a rate closer to 8% or higher.

Here are some tips for boosting your credit score before applying for an auto loan:

 

  • Pay all bills on time – payment history is the biggest factor in your score
  • Keep balances low on credit cards and other revolving debt
  • Limit new credit inquiries by only applying for loans when necessary
  • Correct any errors on your credit report
  • Consider becoming an authorized user on someone else’s credit card

 

Taking steps to improve your credit score even by 50-100 points can make a big difference in the interest rate lenders offer. Those with excellent credit (scores above 750) will always qualify for the lowest rates available.

 

Down Payment Considerations

The size of your down payment can significantly influence the interest rate you’ll pay on a car loan. Putting more money down upfront lowers the amount you need to finance, which allows lenders to offer better rates since you’re borrowing less. Most experts recommend a 20% down payment if possible, but any additional funds beyond the minimum required can lead to interest savings.

With a larger down payment, buyers signal to lenders that they are less of a risk and have the means to handle a big initial expense. Borrowers who make only a small down payment or put nothing down end up financing close to the full purchase price, requiring higher interest rates on the larger loan amount.

Running the numbers illustrates how impactful a bigger down payment can be. For example, on a $30,000 car loan over 5 years:

 

  • 10% down ($3,000) at 4.5% APR results in a $542 monthly payment
  • 20% down ($6,000) at 3.5% APR results in a $495 monthly payment

 

While it requires more cash up front, doubling the down payment amount saves nearly $50 per month, adding up to over $1,400 in interest savings over the loan term thanks to the lower interest rate.

Some buyers take out longer loans of 6 or 7 years to afford higher monthly payments with a smaller down payment. But longer terms mean paying more total interest, so it’s usually better to make a larger down payment if possible and opt for a shorter loan duration.

 

Conclusion

Economic fluctuations cause interest rates to rise and fall over time, but car buyers aren’t helpless in the face of market variability. By tracking key indicators like the Fed funds rate, inflation, and unemployment, consumers can strategize the best times to finance a vehicle purchase. Comparing lenders, loan terms, and financing options expands possibilities for securing favorable interest rates.

The conclusion is that while economic tides are uncontrollable, proactive consumers can still find good auto loan rates amidst the turbulence. Seeking out up-to-date rate information, maintaining excellent credit, putting more money down, and shortening loan lengths are some of the levers buyers can pull to get the most advantageous interest rates on a new or used car purchase.

Armed with the knowledge of what impacts financing costs, and utilizing all available choices, car shoppers can confidently navigate the rises and dips of the auto lending marketplace. Awareness of economic influences plus smart shopping puts consumers in the driver’s seat when it comes to getting the best interest rate, even as market factors ebb and flow.

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Questions About The Economy & Car Loan Interest Rates

Economic fluctuations in Canada can significantly impact car loan interest rates. When the economy is strong, interest rates tend to rise as the Bank of Canada raises its key interest rate to prevent overheating. Higher interest rates make borrowing more expensive. During economic downturns or recessions, the Bank of Canada lowers interest rates to stimulate borrowing and spending. This leads to lower car loan interest rates.

 

Factors like inflation, employment levels, GDP growth, housing markets, and oil prices all impact Canada’s economic health and the Bank of Canada’s decisions on interest rates. As these fluctuate, it directly feeds into fluctuations in car loan rates offered by commercial banks and lenders. Those with variable rate car loans see the most direct impact as their interest rate moves up or down with the Bank of Canada rate.

The current average interest rate on a 5-year fixed rate car loan from a commercial bank in Canada is approximately 5-7%. Rates can vary significantly depending on the applicant’s credit score, loan term, lender, and other factors. Those with excellent credit can qualify for rates as low as 0-2% from some lenders.

Car loan rates in Canada have steadily increased over most of the past 5 years in line with interest rate hikes from the Bank of Canada. Rates hit historic lows during the pandemic around 1-3% for those with the best credit. As the economy recovered and inflation increased, the central bank raised its overnight lending rate from 0.25% to 4.25% over the last 2 years – bringing variable and fixed car loan rates up with it.

The main factors that determine the interest rate offered on car loans in Canada are the applicant’s credit score, loan term, loan-to-value ratio on the vehicle, whether the rate is fixed or variable, market interest rates, and competition between lenders. Those with higher credit scores, shorter loan terms, higher down payments, and who choose fixed rates qualify for the lowest interest rates.

Rising interest rates reduce people’s ability to afford car loans in a few key ways. First, higher rates directly increase the monthly payment on a same-priced vehicle. Second, higher payments mean buyers need to qualify for smaller loan amounts. Third, rising rates impact other debt products like mortgages and consumer credit, increasing overall debt burdens. And fourth, rate hikes tend to correlate with slower economic growth, which can negatively impact household incomes.

The Bank of Canada’s overnight interest rate has a strong correlation with interest rates in the broader economy, including auto loans. This is because Canada’s major banks and other lenders base their prime lending rates on the central bank’s rate. So when the Bank of Canada raises or lowers rates, variable rate products like credit cards and adjustable rate mortgages see an immediate impact. Fixed rate products see a delayed effect as banks reprice new originations.

Recessions typically cause the Bank of Canada to aggressively cut interest rates to spur economic growth. This was evident during the Great Recession in 2008-09 and the COVID-induced recession in 2020. As the central bank rate declined to near zero, lenders dropped auto loan rates to historic lows around 0-3% for prime borrowers. These ultra-low rates expanded affordability and auto sales despite job losses. Rates eventually rise again during the recovery and expansion phase of the business cycle.



Yes, the best way to get the lowest interest rate on a car loan is to have a credit score over 720, choose the shortest loan term you can afford between 2-5 years, put at least 20% down, and compare rates from multiple banks and lenders. Getting pre-approved for financing also puts you in a stronger negotiating position with the dealer to ask them to beat your rate. Having a co-signer with excellent credit can also result in a lower rate.

Auto loans in Canada with 2 to 5 year terms almost always have lower interest rates than 6 or 7 year loans. Shorter term loans represent less risk for the lender so they reward the borrower with better rates. 2 and 3 year car loans have the lowest rates for borrowers with strong credit and down payments. The rate difference between 4 and 5 years is generally small. Very few lenders even offer terms over 6 years because of the increased risk.

Yes, there are lenders in Canada that specialize in offering car loans to applicants with bad credit. Subprime lenders provide loans to those with credit scores below 600. However, the interest rates on subprime auto loans are significantly higher compared to prime borrowers – often over 10-20%. The loan approval amounts are also lower with more stringent terms. Having a cosigner with good credit can help improve the rate on a bad credit auto loan.

Sharp rises in gas prices like those experienced in 2022 can have wide-ranging impacts across Canada’s auto industry. When gas prices spike, consumers tend to prioritize fuel efficiency more highly in their vehicle purchases. This increases demand for smaller cars and hybrid/electric vehicles that offer better fuel economy. It can also weaken demand for trucks and large SUVs. If gas prices sustain higher levels, it may motivate more households to switch to electric vehicles. But it also reduces the budget available for car loan payments, especially among lower income groups.

Most auto loans and leases in Canada do not come with built-in job loss protections. However, some lenders like TD and RBC do offer optional Credit Life & Disability Insurance that can cover car loan payments for a period of time in the event of illness, injury or involuntary job loss. There are also companies like Erickson Living Protection and Solutions Insurance that offer stand-alone job loss insurance to provide monthly payments. The best protection is to have an emergency fund with 3-6 months of living expenses as a buffer.

If rising interest rates make a car loan payment unaffordable, Canadian borrowers have a few options. First, they can contact their lender to discuss a payment deferral plan or re-amortization of the loan term to lower payments. Second, they can try to refinance for a lower interest rate, if their credit score now allows it. Third, adding a cosigner to share payments can provide relief. And lastly, they may need to sell their vehicle and get a less expensive used car with cheaper financing. Defaulting on the loan should only be a last resort given the credit score implications.

Most economists expect auto loan interest rates in Canada will continue rising moderately in 2023 and 2024 but not as aggressively as 2022. Variable rate loans tied to the Bank of Canada rate will see the fastest increases if the central bank continues hiking its benchmark as forecasted to between 4.50% and 5.00%. New fixed rate auto loans will also likely be 50-100 basis points higher over the next two years compared to 2022 averages. But rates are expected to peak and level off by mid-2024.

The best way to secure pre-approval for a competitive auto loan in Canada is to first check your credit report and FICO or Beacon score from Equifax or TransUnion. Then, compare estimated rate offers by applying online with major banks like TD, RBC, Scotiabank, BMO, CIBC and credit unions. Once pre-approved, you can shop for vehicles knowing your maximum loan amount and rate. Dealers will often try to beat an existing pre-approval offer. Having a pre-approval in hand puts borrowers in a much stronger negotiating position.

If Canada enters an economic downturn or recession, history shows that auto loan interest rates could start decreasing in a matter of months in response from the Bank of Canada and lenders. For example, when COVID lockdowns hit in March 2020, the central bank began cutting its key rate that April from 1.75% down to just 0.25% by the end of that year as part of its quantitative easing program. Lenders followed suit dramatically reducing auto and other loan rates through 2020 and 2021 trying to stimulate borrowing. So rates can come down quite quickly with a monetary policy and market response.

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