Why A Used Car Loan Typically Has A Higher Rate
If you’re looking to buy a used vehicle, it may shock you to find that interest rates on used car loans tend to run higher than those on new cars.
There are several reasons for this, and we’ll discuss those here.
Determining Used Car Loan Rates
Before going in-depth into why used car loans tend to have higher rates than new car loans, it’s important to know what goes into determining interest rates in the first place. Ultimately, it all comes down to risk—if something about the car or the buyer would make the loan higher risk, then a higher rate will usually be issued.
Borrower’s credit
The first factor that goes into an interest rate is the borrower’s credit.
If a borrower has proven to be reliable when it comes to paying off debts and meeting financial obligations, that individual’s credit score will be a bit higher, and it will show lenders that they are less likely to default.
On the other hand, a borrower who is frequently late on payments or tends to default on loans will represent a higher risk to the lender. To counteract this, the lender will generally issue a higher interest rate.
Amount borrowed
The amount that is borrowed is another factor lenders consider when issuing a loan.
Typically, the more they lend out, the more risk is involved in the loan. If it defaults, a larger loan means a larger loss.
Also, the more someone borrows, the higher their level of debt will be relative to their income, creating an extra financial strain for them. This could result in late or missed payments, and if the customer’s financial situation deteriorates, they might default on the loan. This is why lenders won’t approve someone for a loan that would put their debt-to-income (DTI) ratio over a certain threshold—it’s too much of a risk if it’s too high.
The larger the loan, the higher the DTI, the higher the interest rate is likely to be.
Loan term
The loan term, or the period in which the borrower has to pay off the loan, factors into the interest rate because a long repayment period means it will take more time for the lender to get a return on their investment. It also means more risk that the loan won’t be paid back, so the higher rate is an attempt to compensate for that.
On the flip side, a longer loan term could put the borrower’s DTI at a lower level by spreading the total loan amount over more months, but you’ll still end up paying more interest overall.
Used Car Loan Vs. New Car Loan
With these factors in mind, let’s look at a few of the reasons why a used car loan will have a higher interest rate than a new car loan.
Difficult to appraise used cars
Used cars are much more difficult to appraise than new ones.
While a new car will depreciate fairly rapidly after being driven off the lot, it does still decrease in value at a fairly predictable rate.
With a used car, it can be difficult to pinpoint its current value. It might have had significant damage in the past warranting costly repairs, or it might have existing issues that neither the buyer nor the seller is fully aware of. Those could impact its value, making it worth less than its actual going price.
Used cars are riskier investments
Used cars are more likely to end up underwater than new vehicles—in terms of financing, that is.
When the borrower owes more on the car than it’s worth, it’s considered to be underwater, and if the lender has to repossess the vehicle, they won’t be able to recover as much from selling it as they would a new car.
When It Makes Sense To Go New
Considering the higher interest rates of used cars over new, it might make sense to go with a new vehicle, especially if your financial situation allows you to do so.
Additional factors that might make a new vehicle purchase more financially beneficial include the following:
Fewer repairs
A new car will need less repair work while you own it than a used one. Every part in the vehicle is brand new, and it will take a while before anything starts wearing out. That could potentially save you on repairs, making a new car a better investment.
No hidden issues
In connection with the lower need for repairs, you probably won’t face any unexpected issues with the vehicle. There won’t be any unreported accidents or undisclosed problems involved with the vehicle—it has a clean slate and represents a low-risk purchase as a result.
Predictable depreciation
New cars have a very predictable depreciation rate, and you’re less likely to end up underwater on the loan. This is particularly true if you can afford a shorter loan term—the sooner you pay off your new car, the lower your chances of owing more than the vehicle is worth.
More efficient operation
New cars also tend to operate more efficiently than used since everything is new and in perfect repair. As long as you keep the vehicle well maintained, it should use less fuel than something with parts that have been allowed to wear out.
Choosing A New Or Used Car Loan
Whether you decide to go used or new will ultimately depend on your financial situation and current needs. Consulting with your lender can help you know where you stand in terms of finances and assist you in getting the best new or used car loan available.