How Interest Rate Increases Could Put The Brakes On Your New Car Purchase

How Interest Rate Increases Could Put The Brakes On Your New Car Purchase

2013 was a good year for auto loan interest rates, hovering nearly around 2.5% for those with good credit and 4-5% for those with imperfect credit (defined has having FICO scores between 540 and 620 FICO).  Experts predict that auto financing rates for 2014 will most likely stay steady.  However, long-term U. S. interest rates are rising.  What would happen if auto rates rose along with them?  Would you still be able to afford a new car?

A decrease in unemployment could spark a rise in rates.   Long-term interest rates, the rates that banks charge their customers for loan products, have already risen as a result of the improving job market.  Short-term interest rates, the rates that bank charge each other for money lending, have not moved and are not projected to move unless unemployment dips below 6.5%.  (The unemployment rate currently sits at 6.7% per kiplinger.com)

When, and not if, short-term interest rates increase, there will be a corresponding additional increase in long-term interest rates, affecting a consumer’s ability to borrow.  When making a decision on whether or not to lend, a financial institution looks at both debt ratios and credit ratings.  Higher interest rates can throw both these elements in your financial profile out of whack.

Your debt ratio results from the division of your total monthly payments by your gross monthly income. What is too high a debt ratio?  Most banks like to see a debt ratio at or below 36%.   For example, if your total monthly income is $5000, a 36% debt ratio is $5000 x .36 or 1800 dollars.   If your total payments exceed 36% of your monthly income, you will not qualify for the lowest rate auto loan.

You should know in advance before shopping for a car what your debt ratio is.  With this knowledge you will be able to determine how much “room” you have for an additional payment.

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To determine your total payments, add together all monthly liabilities for auto loans, student loans, credit cards and mortgages.  For the purposes of determining debt ratios, you don’t need to consider things like groceries or utilities.  If you rent instead of owning a home, you will also need to factor in your rent.  A good way to make sure you have included all your payments is to pull your credit report.  Any lending institution will use payments listed on your credit report when calculating your debt ratio’s numerator (the denominator, i.e., your self-reported income, doesn’t appear within credit reports),  so you should know what is on there.

To determine what your auto payment might be like for any particular vehicle’s price tag (so you can add it to your total liabilities), there are a number of excellent calculators on the web.  In order to use a loan calculator, you need to know what interest rate to use and this is based on the kind of credit you have. CreditKarma.com is a good place to get a close estimate of what your Transunion credit score is.  Once you know your score, do a search for what current auto loan rates are online and add .3 percent to the good credit market rate for every 20 points you are below 740.  Example: if the going rate is 2.5% and your credit score is 700, add .6% for an interest rate of 3.1%.  Using such numbers, your new car payment should be a close approximation.

With regard to housing, adjustable rate mortgages have once again become popular, as they allow people to qualify at a lower starter rate.  If you currently have an adjustable rate mortgage (ARM) and long or short-term interest rates go up, your home loan payment will also rise, increasing your debt ratio, so beware.

Determining your total income involves combining everything you make per month.  Make sure you take into account you and your spouse’s take home pay and income from investments.

If you determine that your new car payment will make your debt ratio too high, you could buy a cheaper car or get into an alternative loan product (at a higher interest rate) that accepts applicants with ratios above 36%.  You could also get a co-signor on the loan to add extra income (and potentially higher credit) in order to qualify.

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When long-term interest rates go up, your credit may take a hit due to increases in your credit card rates.  Here’s how:

Credit utilization, the amount of used credit divided by your available credit, factors heavily into your credit score.  Using more than 30% of your credit line has been shown to dramatically decrease your score.  Despite the fact that the interest rate may have increased, your minimum payment may not.  If you can only afford the minimum, balances on your credit cards could increase every month, lowering your credit score.

Take the following example: your current credit card has a balance of $5000, your interest rate is 18.9 percent and the minimum payment percentage is 4%.  According to a calculator on bankrate.com, the time to pay off the balance is 11 years and 5 months.   Should the interest rate go up to 20.9%, assuming the minimum payment percentage doesn’t change, the time to pay off the balance is 12 years and 2 months.    Your balance will stay higher for a longer (much longer!) period of time, and your credit score will suffer.   (That example should also be showing you why you should always pay more than the minimum, by the way.)

If your credit score is lower, you may get bumped you into a loan product with a higher interest rate.  This in turn may increase your debt ratios (higher interest rate, higher payment).  You increase your likelihood going above of the target 36% – and being denied for credit.

Despite the fact that interest rates have reached historic lows when it comes to auto loans, it pays to keep track of where the market is heading if you are considering purchasing a new (or newer) car in the next 3-6 months.   If your credit is marginal or your debt too large, you need to pay extra attention, as higher interest will cost you in more ways than less money in your wallet.  Being proactive, like pulling your credit reports and analyzing your debt ahead of time, may lead to more realistic and intelligent choices and avoids the embarrassment of being declined for a new loan.

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