If you’re in the market for a car, you have three options: buy used, buy new or lease. If you rule out leasing and decide you want to own, you’ll have to weigh the pros and cons of new cars vs. used cars. Although the out-of-pocket cost of owning a used car is generally lower, car finance interest rates are likely to be significantly higher for used cars than for new cars.
Why are used car loan rates higher? Here are five answers to your question so you can understand the ins and outs of car loan rates before you buy.
5 Reasons Used Car Loan Interest Rates Are Higher Than for New Cars
Rarely will two people get the same interest rate if one is buying new and the other is buying used. In fact, the average interest rate is more than four times higher for those who buy used, according to Edmunds. Here are five reasons why:
1. Used Car Values Are Harder to Estimate
New cars lose value quickly — the minute you drive it off the lot it loses around 10 percent of its value, according to CARFAX. A used car’s value can be harder to calculate because there is a greater chance the car has mechanical problems, unreported accidents or other issues. For used car dealerships, which typically provide financing options and might need to repossess vehicles, not knowing a car’s value can make a risky investment.
To mitigate the inherent risk in financing older vehicles, a lender will usually reserve the best car loan interest rate for new car buyers. Alliant Credit Union, for example, offers current auto loan rates as low as 1.99% APR with a fixed rate for new vehicles but only 2.24% APR on used vehicles, as of Jan 12, 2017.
Another example is Utah Community Credit Union, which offers a 2.89% APR on auto loans up to 60 months for vehicle model years 2007 to 2017. If a vehicle was manufactured between 2002 and 2006, however, rates start at 3.19% APR.
2. Used Car Borrowers Have Lower Credit Scores
Used car buyers tend to have lower credit scores, according to Edmunds. This is another reason why used cars carry higher interest rates. Lenders make up for the inherent risk they take by offering subprime loans or refinance deals by charging higher interest rates. Subprime loans are auto loans reserved mostly for buyers with less-than-stellar credit. By charging a higher rate, the lender mitigates the risk of default.
Here’s a look at the average rates for a 60-month auto loan based on your credit score:
|Auto Loan Rates Based on Credit Score (APR)|
|579 and lower||20-24%|
|Data from CarMax, accurate as of Jan. 12, 2017.|
3. Manufacturers Incentivize New Car Purchases
Many major auto manufacturers make money through financing new cars. Dealers serve as middlemen and take a commission on each sale — and that commission is often hidden in the financing.
Dealerships can also profit from new car sales through dealer holdbacks. A holdback is money a manufacturer pays a dealer for selling a new car. Holdbacks incentivize dealerships to focus on new car sales by allowing them to advertise cars for near-invoice prices, according to RealCarTips.com.
4. Used Car Borrowers Are Risky
The riskiest borrowers — and those who are least likely to qualify for a new car loan — are increasingly likely to default, according to USA Today. Subprime auto delinquencies rose by 22 percent over last year, putting pressure on used car dealers.
Because buyers with low credit scores are less likely to be approved for new car loans, many opt for used cars. As more people with low credit scores purchase used vehicles, lenders are more likely to increase rates to offset their losses in the case of loan default.
5. Used Cars Are a Bigger Liability
Lenders also have to account for the fact that they might have to repossess some of the cars they sell. Some of those repossessions might be upside down, which means the borrower owes more to the lender than the car is worth. When a lender repossesses an upside down vehicle, he might sue the borrower to make back the money he lost on the vehicle’s value.
Another reason used car rates are higher is because the older your vehicle, the less your lender will be able to resell the car after he repossesses it if he has to, according to DMV.org. A new car that is repossessed, on the other hand, will still have a higher resale value, allowing the lender to make back the money he lost on your defaulted loan.
Should You Buy a New or Used Car?
Although interest rates for used cars are higher, you might save more on the total cost of a used car. Cars suffer the steepest and most rapid depreciation in the first year of ownership, according to Edmunds. As the car ages, its value depreciates more slowly.
You can also buy used cars for less than new. You might pay a higher rate on a used car because your vehicle does not depreciate as quickly as a new car, but you’ll lose less money over time on your investment. In the end, out-of-pocket costs are generally the highest for new car purchases, buying used is the cheapest option and leasing falls somewhere in between.
Even with a lower rate, a long-term auto loan will cost nearly the same amount as a higher-rate, short-term loan. In the following example, a long-term loan with a 1.99% APR will cost nearly $175 less over the life of the loan, but it will keep you in debt for an additional three years more than a 48-month loan with a 3.99% APR.
|Total Cost of a $15,000 Auto Loan|
|Rate (APR)||Term||Monthly Payment||Total Cost|
|High-rate, short-term loan||3.99%||48||$339||$16,254|
|Low-rate, long-term loan||1.99%||84||$191||$16,081|
As you consider vehicles for sale, review maintenance records and ask about previous accidents. If you are in touch with the previous owner of the vehicle, inquire about any problems he encountered. Finding a used car in good mechanical condition can help you save money, regardless of the loan rate.
Keep Reading: 3 Things You Should Never Tell a Car Salesman