Fluctuating rates mean you’re gambling on the market.
Though fixed-rate car loans are still the most popular, lenders are slowly beginning to offer variable-rate options as well. A variable-rate loan can offer lower rates if the economy takes a downturn. But they can also rise suddenly, making it a somewhat risky option.
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What is a variable-rate car loan?
A variable-rate car loan has an interest rate that changes based on the Wall Street Journal prime rate. This is the rate most big US banks give their most creditworthy borrowers, which fluctuates based on changes in the lending market and economy.
Because of this, the variable interest rate you first receive when you take out your car loan isn’t guaranteed to stay the same throughout your loan term — it could go up or down depending on market trends.
While this means you could see lower rates when the economy is stable or on the decline, there’s also the risk of the prime rate skyrocketing during periods of prosperity. And if your lender doesn’t have a variable rate cap, there’s no limit to how high your interest rate could go.
3 factors to consider with variable-rate car loans
To avoid ending up in a bad financial situation, pay extra attention to these factors before taking out a variable-rate loan:
- Loan term. A variable-rate car loan with a longer term means there’s more time for your rate to increase, which ups the risk of ending up with high monthly repayments that are difficult to afford.
- Rate cap. Look into whether your lender offers a maximum variable rate — if not, there’s no limit to how high your rate could soar. This could lead to unaffordable repayments, increasing your risk of default.
- State of the economy. If the prime rate is expected to rise in the coming months, you might want to opt for a fixed rate. On the other hand, if the economy’s hit a slump and the prime rate is expected to decrease, you might save with a variable rate.
What are the different types of car loans with a variable rate?
When it comes to car loans with variable rates, there are two main loan types:
- New car loans. Lenders tend to offer lower rates across the board for new vehicles, since these cars offer something more valuable to the lender should you default.
- Used car loans. Whether you’re looking to buy a used car from a dealership or private seller, used car loans tend to have higher starting fixed and variable rates. This is because there’s more of a risk to the lender should you default, since your car isn’t as valuable as a new car would be.
4 questions to ask when comparing variable-rate car loans
Consider the following factors to compare your variable-rate loan options and find the right one for you:
- What interest rate will I be charged? Even though the rate is variable, looking at the rate that applies to the loan when you’re comparing will give you an idea of the competitiveness of the product.
- What fees come with the loan? Look for upfront fees such as origination fees as well as ongoing fees such as monthly and annual fees.
- Can I make additional payments? Variable-rate loans tend to be more flexible in terms of allowing additional payments to quickly pay off the loan. But in some cases you can be charged a fee, so check with your lender.
- Can I repay the loan early without penalty? Check if an early prepayment or early termination fee applies.
Bottom line
Variable-rate car loans have the potential to save you money on interest should the market take a hit. But you also risk ending up with unaffordable monthly repayments if the prime rate increases — especially if your lender has no variable rate cap.
If you’re not willing to take the gamble, compare other car loans to find one that’s the right fit for your financial situation.