How do higher interest rates impact car finance and car loans?
How do higher interest rates impact car finance and car loans?
Introduction.
In recent times, the car-financing landscape has experienced a significant shift, with car finance interest rates soaring from historically low levels below 2% to surpassing 8% today. This increase in the cost of financing has far-reaching consequences, particularly for those that live in and around the expanding Ultra Low Emission Zones (ULEZ) of our large cities.
In this article, we will outline the implications of higher car loan interest rates and explore how these changes impact the real cost of purchasing a car today.
What are the different types of car financing?
Just to recap for those not entirely familiar with the different types of car financing available, the market typically offers these options:
If you want to own the car:
Buy the car outright with cash. You own the vehicle and you decide when you want to sell the car, taking the full hit of any depreciation. There is no interest to pay and no one can take the car from you.
Buy the car with an unsecured bank loan. You own the vehicle and you decide when you want to sell the car, taking the full hit of any depreciation. You pay interest on the full value of the car but no one can take the car from you.
Hire Purchase (HP). Essentially a secured loan for the entire value of the car and you will own the car at the end of the term. You pay interest on the full value of the car. The finance company can take the car back if you are unable to repay the loan.
If you don’t want to own the car:
Private Contract Purchase (PCP). You finance the value of the car, minus the future value of the car at the end of the term. You don’t own the car unless you pay the final balloon payment. You pay interest on the depreciation of the car over the term. The finance company can take the car back if you are unable to repay the loan.
Leasing. You rent the car over an agreed period and you never own the vehicle. The future value of the car is not your concern as you simply hand the car back. Interest is included in the lease cost and is not always clear how much this is as lease companies often receive heavy discounts on bulk orders. The leasing company can take the car back if you are unable to make the payments.
How do increased car loan interest rates affect car buyers?
One of the primary areas where higher interest rates leave an indelible mark is on consumer behaviour. As interest rates rise, potential car buyers face increased borrowing costs and higher monthly payments, prompting them to re-evaluate their purchasing decisions.
Previously, with car loan interest rates hovering below 2%, car loans were more affordable, and consumers were able to purchase more expensive vehicles, in the same way that home buyers were able to purchase ever more expensive properties. However, the paradigm shift to typical car loan interest rates surpassing 8% requires potential buyers to carefully consider their financial capacity before committing to a car purchase.
How do increased car loan interest rates affect affordability and loan eligibility?
Higher interest rates inevitably translate to elevated monthly loan repayments for those seeking to finance their car purchases. As such, the affordability of a car diminishes significantly as the higher cost of borrowing erodes purchasing power. The increase in interest payments often results in potential car buyers either downgrading their vehicle expectations or delaying their purchase.
Moreover, the tightening of credit standards by financial institutions is a common response to rising interest rates. Lenders may become more stringent in assessing loan eligibility, making it challenging for certain individuals to secure car loans. This can have a cascading effect, impacting the overall demand for cars and subsequently affecting car manufacturers and dealerships.
How do increased car loan interest rates affect resale value and depreciation?
As higher interest rates influence consumer demand and purchasing power for new vehicles, it also impacts the resale value of used vehicles. With this demand reduction, the prices of used cars may experience downward pressure, leading to higher depreciation rates for those who recently purchased vehicles. Consequently, borrowers might find themselves owing more on their car loans than their vehicles are worth, a phenomenon commonly referred to as being in negative equity.
These depreciation figures will also be reflected in the ‘Final Payments’, ‘Balloons’ or ‘Guaranteed Future Values’ on car finance agreements. As such, not only will the buyer have to pay higher monthly payments to cover the increased interest rates, but the buyer will also have to finance a larger percentage of the value of the vehicle over the term to cover the increase in depreciation.
What does an increase in the interest rate of a car look like in real life?
A client of ours was recently looking to purchase a new car with a value of £30,000 and was considering PCP as this options offers a lot of flexibility and is one of the most popular ways to finance a car in the UK. In 2020, the manufacturer was offering PCP financing at 1.9% over 42 months (3.5 years). Today, for the same car, the PCP interest rate being offered is 8.4%.
Car financing illustrated at 1.9% with low deprecation.
10% cash deposit of £3,000.
Low depreciation model (-29.57% over 3.5 years).
Monthly payment of £178.
Total interest paid £1,607.
Total paid £10,477 + optional balloon payment of £21,129.
Car financing illustrated at 8.4% with low deprecation for level comparison.
10% cash deposit of £3,000.
Low depreciation model (-29.57% over 3.5 years).
Monthly payment of £309.
Total interest paid £7,137.
Total paid £16,008 + optional balloon payment of £21,129.
Car financing illustrated at 8.4% with high deprecation for a realistic comparison.
10% cash deposit of £3,000.
High depreciation model (-61.4% over 3.5 years).
Monthly payment of £506.
Total interest paid £5,835.
Total paid £24,254 + optional balloon payment of £11,580.
How do these examples compare?
The first car financing illustration at 1.9% clearly offered the most favourable interest rate, resulting in the lowest total interest paid. In the second illustration, where the depreciation was still comparable, the increase of the interest rate to 8.4 nearly doubles the monthly payment for the buyer.
Interestingly though, when we compare the total amount paid, the final illustration with higher depreciation actually results in less total interest paid because more of the capital is being paid off over the term. This option clearly reduces the risk for the lender but does dramatically increase the monthly payment for the buyer to nearly three times the original illustration and the total amount paid over the agreement is over double.
It’s fair to say that in these less-certain times, the lender is looking to secure excess profits by charging well over the base rate for the loan, whilst decreasing their risks by giving a significant under-valuation when calculating their balloon payment. If the buyer hands the car back at the end of the term, the lender will have secured an excellent return from their interest rate and may even have an asset worth significantly more than their ‘guaranteed future value’.
Conclusion.
The recent surge in car finance interest rates, moving from below 2% to over 8%, could significantly impact the automotive industry. Consumer behaviour and purchasing power will be directly affected, with potential buyers likely forced to reassess their car purchase decisions in light of these higher borrowing costs. Affordability and loan eligibility will also become major concerns, leading to shifts in the market dynamics and the overall demand for vehicles.
Importantly, the rise in interest rates has implications for the resale value and depreciation of cars, potentially leaving borrowers with loans exceeding their vehicle’s value or, as may be the case, manufacturers looking to protect their downside by deliberately passing on the risk of depreciation to customers in the form of lower balloon payments and guaranteed future values.
In this dynamic and evolving scenario, it is essential for buyers to look at the overall cost of financing and to pay particular attention to the interest rate, monthly payment and balloon payment to take an overall view of value. It may well be worth comparing the various financing options to establish a package that works best for you, particularly if the vehicle is unlikely to be kept for life.
What’s next?
If you need help or advice on your personal or business finances or if you want to consider investing to make your money work harder, you can get in touch with one of our advisors for independent financial advice. We offer a free initial consultation and although we are based in Tunbridge Wells, we advise clients across the UK.
Don’t forget, this article offers general financial information and should not be taken as personal advice. Remember that investments and pensions can go up and down in value, so you could get back less than you put in. Tax rules can change and the benefits depend on individual circumstances.