How do interest rates work on car loans?

If you’re planning to buy a new or used car and need to borrow money to finance your purchase, there are various types of loans to choose from. Regardless of the agreement you opt for, you will be required to pay interest. 

Read on to find out more about your options and the sort of interest rates you can expect to pay.

Lease, sale or return

Personal contract plans are where you lease the car for a monthly sum, rather than ever owning it outright.

Hire purchase agreements also involve fixed payments, but give you the option of buying the car at the end for an additional fee.

Conditional sale agreements are designed for those who know they want to own the car at the end of the agreement. Once the final instalment is paid on these deals, the car belongs to you.

Car loans

There are also car loans available, with two main types on the market - personal loans or fixed sum loans.

Personal loans are a good bet for those with a good credit rating, and those who want to own the car from the beginning.

Fixed sum loans are secured on the car, so unlike with personal loans, you don’t fully own the car until the loan is repaid. This means you cannot modify or sell the car while the loan is being paid. However, one plus is that you can get help from the lender if there are issues with the car during the first six months.

In your interest

So, how do interest rates work on car loans? Put simply, the interest rates decides how much extra you will pay for the car, above the actual sum borrowed.

If you take out a car loan, what you pay in real terms for the car is determined by the interest rate. It’s very important to get the best possible deal, as a lower rate will mean you pay back less money.

You will borrow a set amount to buy the car - either its full price or the price minus a deposit, if you have one. The interest is then added to this amount to get the total amount you will pay. This is then divided into monthly payments.

Car loans are generally generally available with repayment periods of between one and seven years, with the majority of loans having terms of two to five years. Usually, the more you borrow, the better rate of interest will be applied. This rate is referred to as the annual percentage rate, or APR. When you’re looking at car loan options, you can compare the APRs to see which offers the best value.

It can be more complicated than it seems, however. The advertised rates are ‘representative’ APRs. Regulations mean that at least 51% of people who apply for the loan must get that rate, but the other 49% may not. Some, or even many, of that 49% might be given a higher rate.

Points to consider

There are a number of factors that can affect the interest rate you pay. As mentioned previously, lower rates tend to be available for bigger loans. So, if you’re only borrowing a small amount, you will probably face a higher rate of interest.

Your credit score will also have a big impact on the interest rates offered to you. If you have a favourable score, lenders will see you as lower risk - and will therefore be prepared to lend to your at lower rates of interest. Conversely, if you have a poor credit rating, you will be viewed as higher risk and may only have access to less competitive deals in terms of interest rates.

So, if you currently have a bad credit rating, it could be beneficial to take steps to improve it. There are a number of ways to do this. For example, if you aren’t on it already, get on the electoral register. Try to keep up with any existing loan and credit repayments too, as this will help you to build up your score.