What Happens to My Car Loan if Interest Rates Drop?

What Happens to My Car Loan if Interest Rates Drop?

When interest rates fall, it can affect car loans in different ways, depending on whether you have a fixed-rate or variable-rate car loan.

Fixed-Rate Car Loans

Most car loans come with a fixed rate, meaning you have the same interest rate throughout the entire repayment term. These loans are often ideal for longer-term financing because they come with predictable monthly payments.

If interest rates drop, your car loan payment won't change at all, regardless of what's happening in the market.

Variable-Rate Car Loans

A variable-rate car loan has an interest rate that may change periodically because it's tied to an underlying benchmark, such as the prime rate. So the interest rate can change with market conditions. Borrowers may choose this type of loan because they often come with a low introductory rate.

But when economic forces push a benchmark rate higher, your car loan's rate can go up too—and your monthly payment would follow suit. If interest rates drop, your rate may decrease, thereby lowering your monthly payments.

Learn more: Fixed-Rate vs. Variable-Rate Car Loans: Which Is Better?

Should I Refinance My Car Loan if Interest Rates Drop?

Falling market rates may help you refinance your car loan at a lower interest rate, which could help you save money. Refinancing could also make sense in a few other scenarios:

• Your credit score has improved. You may qualify for a lower interest rate if your credit scores are higher now than they were when you initially took out your car loan. Check your credit scores to see where you stand.
• You've built equity in the car. With a cash-out auto refinance, you replace your current auto loan with a new, larger loan and keep the difference in cash. This may be a good option if you need money for other expenses and you've built equity in the car.
• You have a variable rate. A variable-rate car loan often comes with a low introductory rate, which helps borrowers afford their monthly payments in the beginning of the loan. But if you want more predictable payments, you could refinance into a fixed-rate car loan.
• You're having trouble making payments. Refinancing into a lower-rate loan can help reduce your payments when you're struggling. If you don't qualify for a lower rate, you can extend your loan term, which lowers your payments. The longer loan term will add to your interest costs—but when you're financially stable again, you could pay extra toward the principal.

Does a Car Loan Refinance Make Sense?

A car payment calculator can help you compare refinancing options with different loan amounts, interest rates and repayment terms. You can then use the information to decide whether refinancing makes financial sense for you. Start by plugging in different scenarios.

Example: Let's say you originally bought a $45,000 car, made a $5,000 down payment and had a loan with a 60-month term, a 7.5% rate and a $5,000 down payment. You would pay about $8,091 in interest costs if you followed the original payment schedule. But 12 months into the loan, you qualify for a 5% rate, and you consider refinancing into a new 48-month loan.

You've already paid $3,276 in interest on the old loan, and a new 48-month loan at the lower rate would cost $4,055 in interest. With a total interest cost of $7,331 with the new loan, you'd save $760 by refinancing.

Also consider any fees you may pay when using this strategy. For instance, your current lender may charge a prepayment penalty for paying off your auto loan earlier than agreed. And your new lender may charge an origination fee when you refinance.

Before refinancing, weigh the fees against your potential interest savings to see if it's worth the hassle.

How to Prepare for Future Interest Rate Drops

Auto loan interest rates respond to changes in the economy, so they may dip at some point in the future. If you think you'll want to refinance eventually, start preparing your finances now. An improved financial standing can help you qualify for a new loan and secure a favorable interest rate.

Here are some strategies to try:

• Identify ways to boost your credit scores. The steps you can take to improve your credit profile can include paying all your debts on time and lowering your credit card balances.
• Pull your credit reports. Look for any inaccuracies that could be hurting your credit scores, check for signs of identity theft and identify areas you can improve. You can dispute inaccuracies with the credit bureaus, and you have the right to place a fraud alert to protect your reports.
• Reduce your debt-to-income ratio (DTI). Your DTI ratio measures how much you're paying toward debts each month relative to your income. Someone with a high DTI ratio might struggle with new car loan payments or getting approved for a refinance. You could lower your DTI by paying off debts, increasing your income or doing some combination of both.

You can also monitor auto loan rates to determine when it's beneficial to refinance your car loan.

The Bottom Line

When interest rates drop, your loan terms won't automatically change if you have a fixed-rate auto loan. Refinancing into a lower-rate loan could help reduce your monthly payments. But if you took out a variable-rate car loan, your lender may reduce your rate—and your monthly payment.

Preparing your finances now will ensure you have options the next time interest rates drop. You can start by monitoring your credit for free with Experian to see where it stands and to receive alerts when changes to your credit report occur.