A few weeks ago, the US Federal Reserve bumped interest rates by 0.25%. It is the first rate increase since December 2018 and signals a change in government direction, with more hikes expected at each of the remaining Six Federal Reserve meetings throughout 2022. The situation is not too different in neighbouring Canada, where the country’s Central Bank also hiked its key interest rate to 0.5%.
The underlying reason is the same in both cases – an attempt to rein in surging inflation. In 2021, inflation in the US peaked at 7%, a 40-year high, while Canada’s 5.1% inflation rate in January 2022 was the highest in 30 years.
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For the automobile sector, these rate increases kick off yet another chapter in a line of events that began when the COVID-19 pandemic took a whack at the fragile global economy. Then we had the supply chain crisis and the ongoing semi-conductor chip shortage. Consequently, in the US, prices of new and used vehicles rose by as much as 11% and 31%, respectively, in 2021. Car buyers suddenly found auto loans an attractive pathway to owning a vehicle. Now, that option may have just lost some of its shine with the recent rate hikes.
Calculating Auto Loan Rates
As stated earlier, auto loan amounts increased significantly in 2021 as consumers patronized lenders to finance the acquisition of new and used vehicles. One of the most significant components of auto loans is the interest rate. It directly influences what the borrower pays over the life of the loan and, by implication, the eventual cost of the vehicle at the end of the term.
Interest on an auto loan is usually calculated using simple interest and not compound interest. This implies that the interest portion doesn’t earn interest. A typical auto loan is also packaged to front-load the interest payable. The borrower gradually pays less interest, and more principal amounts as the loan matures.
Factors that influence how auto loans are structured include the loan term and down payment. A longer-term loan can lower the monthly payments the borrower has to pay. However, the total interest is higher, leading to a higher total cost for the car. Down payments can also help lower the financed amount; the higher the down payment, the lower the auto loan amount. The down payment also allows the borrower to be flexible with the other loan terms, such as opting for a shorter loan tenor to reduce the overall cost of the car.
The Risings Rates And Implications For The Automobile Sector
The rising interest rates already has the automobile industry on edge. The rate spikes will automatically pull up the prime lending rate, which will, in turn, lead to an increase in the cost of borrowing. Low-interest loans will start to dry up, and one can expect to see higher interest loans, tighter credit and lending caps.
Industry experts are already predicting the automobile industry could lose several billions of dollars as consumers shy away from auto loans. The ones who go ahead can opt for longer-term loans, offsetting higher rates and sales prices by taking out longer loans and paying more interest over the life of the loan. A fixed-rate auto loan will also protect buyers from future rate hikes; however, interest rates are typically higher in this case than with variable-rate financing.
Besides auto loans, prospective buyers can also deploy non-conventional options to purchase a vehicle. A good example is the HELOC (Home Equity Line of Credit). As the name implies, it is a revolving line of credit secured by a home’s equity. Under this arrangement, the borrower is typically approved for a certain sum based on factors such as credit history, income and the amount of the home equity. The borrower can then use this amount (the whole approved sum or a portion) for different purposes.
The advantages of HELOC include longer repayment terms, more bargaining power with dealerships and lower interest rates. However, it is important to carry out your proper due diligence before going down this route. HELOC is essentially a second mortgage, and there is the added financial risk of losing your home due to unforeseen circumstances. Remember, your property serves as collateral for the line of credit. Also, using HELOC means you are tying the value of your home to the vehicle, which is a depreciating asset that can rapidly lose its value over time.
Shopping For A Vehicle When Interest Rates Are Higher
Regardless of how you structure your auto loan, rising interest rates will ultimately increase the overall cost of a car. However, certain options and strategies can help ensure that you secure the best possible deal under the present circumstances. Once you have identified the available vehicle options within your budget, We strongly recommend that you compare the prices from multiple dealerships before making the final buying decision.
Similarly, shopping for the best interest rates before taking out an auto loan is a must. There are lots of resources out there to help you find the best interest rates. This auto loan interest rate guide from MarketWatch is an excellent resource that is updated regularly. Among other things, the rate guide identifies the top auto loan providers, the loan application process and helpful tips on what to watch out for before making your choice.
As mentioned earlier, the March rate hike is just the first of a six-part increase. The implication here is that vehicle prices will almost certainly trend even higher. It, therefore, becomes crucial to be very deliberate about planning your next vehicle purchase. Harness every resource available to you to mitigate the effects of rising prices as much as possible.