Why do car loan interest rates change with Federal Reserve rate hikes?

About interest rates and the Federal Reserve

Have you ever seen interest rates slowly increase over time and wonder what causes those changes? In the United States, the Federal Reserve sets monetary policy, which has a large impact on interest rates. Changes in interest rates can have an important effect on the economy. Higher interest rates make borrowing more expensive, which can lead to slower economic growth. Lower interest rates can spur economic activity by making it less expensive to borrow money.

How Federal Reserve rate hikes affect car loan interest rates

When the Federal Reserve tightens monetary policy by raising the federal funds rate, it affects other borrowing rates in the economy. This can include a rise in the prime rate, which is the rate that banks charge their customers who borrow money. As a result, car loan interest rates usually also rise. This can have an impact on both new and used car buyers. If you're considering a car purchase, it's important to be aware of how changes in interest rates can affect your monthly payments.

The Federal Reserve's federal funds rate is the rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. The federal funds rate is critical in determining the interest rates that banks charge consumers for loans. When the federal funds rate goes up, interest rates on credit cards and loans also go up.

The target federal funds rate is set by the Federal Open Market Committee (FOMC). The FOMC meets eight times a year to determine whether to increase, decrease, or leave the target rate unchanged. The committee bases this decision on many factors, including inflation, employment levels, and economic growth. The current target range for the summer of 2022 is 2.25% to 2.50%, according to Forbes. That means the federal funds rate can be anywhere in this range.

The role of the prime rate in car loan interest rates

When it comes to car loan interest rates, the prime rate plays a major role. The prime rate is the interest rate charged by banks on loans to their most creditworthy customers. Forbes states the rule of thumb for the prime rate is taking the federal funds rate and adding 3. For example, if the federal funds rate range is 2.25% to 2.50% for 2022, the prime rate would be around 5.25% to 5.50%. This rate is used as a benchmark for other interest rates, including car loan rates. When the prime rate goes up, so do car loan rates. And when the prime rate goes down, car loan rates usually follow suit.

For consumers, this can be good or bad news depending on what you are trying to do. If you're in the market for a new car and interest rates are on the rise, it may be best to wait until they start to fall again. On the other hand, if you're looking to refinance your existing car loan and continued rate hikes are expected, taking advantage of the current lower prime rate could mean you'll save money on interest by doing so sooner rather than later if rates increase.

What about APR?

The car loan's annual percentage rate, or APR, is also tied to the interest rate and is impacted by rate hikes and changes in the prime rate. This is because the APR takes into account the total cost of the loan including the interest rate, fees, and other factors included in the total cost of borrowing money. The relationship between interest rate and APR demonstrates that if interest rates rise, APRs rise as well.

How lenders set consumer interest rates on car loans

On top of the base prime rates passed down to lenders from the Fed, you will also see a range of interest rate offers when financing or refinancing. The interest rate offers you may see when refinancing your car loan are set by lenders and depend on a number of factors including the type of vehicle being purchased, the borrower's credit score and history, and the length of the loan. One of the most important factors is the year and type of vehicle being purchased. Loans for newer cars generally carry lower interest rates than loans for older models which are normally associated with higher interest rates. Another important factor in setting interest rates on car loans is the borrower's credit score and history.

Borrowers with good credit scores in the prime or super prime brackets with scores in the upper 600s or 700s will usually qualify for lower interest rates than those with poor credit scores in the subprime or nonprime ranges in the 500s and low 600s. The length of the loan is also a factor in determining the interest rate. Shorter-term loans, like 36 months, generally have lower interest rates than longer-term loans, like 72 or 84 months, because lenders perceive them as carrying less risk.

When you apply to a lender for refinancing and qualify for an offer, your rate is locked in and will usually be available for a set period of around 30 days. You can use this to your advantage by waiting to see if rates rise during this time frame. It could also give you more time to make sure accepting the offer is the best choice for your financial situation.

So what does a Fed rate hike mean for car buyers?

A rise in the Federal Reserve’s target rate can mean higher interest rates on new and existing car loans. For example, the monthly payment on a typical $25,000, five-year used car loan would increase by about $16 if the Fed raises its rate by a quarter point, according to Edmunds. They also report a new car loan of around $31,000 and would see a monthly payment increase of about $28 with a quarter-point Fed rate hike.

Wrapping up interest rate hikes

The thing to remember when reviewing available interest rates is to assess where the rates are heading, how factors like inflation are being managed, and what the Federal Reserve is forecasting. With these factors in mind, consider how they apply to your auto loan. If interest rates are steadily increasing and you need to finance or refinance your car, doing so sooner than later may save you money. Remember you can always lock in your rate now and use the qualification window to your advantage.

Rate hike FAQs

• How do rate hikes affect car loan interest rates? Rate hikes increase car loan interest rates since they cause the federal funds rate to rise. This results in an increase in the prime rate, which is the interest rate banks charge their customers who borrow money to buy cars.

• What is the federal funds rate? The Federal Reserve's federal funds rate is the rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

• What is the prime rate? The prime rate is the interest rate charged by banks on loans to their most creditworthy customers.

• How is APR affected? The car loan's APR is tied to the interest rate and is impacted by rate hikes and changes in the prime rate. This is because the annual percentage rate includes the total cost of the rate increases.

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