What changes auto loan rates?

The federal funds rate, from which the prime rate is derived, is the target rate set by the Federal Open Market Committee. Since December 2008, the rate has been at a range of zero percent to 0.25 percent.

If the federal funds rate isn't moving but interest rates on various products are, what's driving rate changes? Below, Bankrate shows you what is causing rate changes in mortgages, home equity loans, auto loans, CDs and money market accounts and credit cards.

Auto Loans

It's no coincidence that auto loan rates for the most creditworthy buyers have hovered around the same low range since the Dec. 18 Fed meeting that cut the federal funds rate to a range of between .25 percent and zero percent. But the Fed's moves are only one part of how financial institutions set interest rates for auto loans for new and used cars.

First is their cost of funds: how much it costs them to do business, how much it costs them to get the money and, in the case of banks, how much they pay to depositors.

Ultimately, the actions of the Federal Open Market Committee, or FOMC, affect the cost of funds.

"To the degree that the market rate, whether it be the federal funds rate, LIBOR or whatever it may be are going up or down, that certainly impacts the cost of funding, which then impacts the loan rates in the marketplace," says Richard Van Leeuwen, an independent consultant specializing in auto finance.

Then and now
ProductRate on
Dec. 18, 2008
Rate on
Aug. 5, 2009
48-month new-car loan7.03%7.02%
36-month used-car loan7.75%7.86%

The Treasury Department within the bank will determine and assign the cost of funds in the form of a percentage or basis points. From there, the cost of funds is assigned to other departments.

"For example, let's say there is a cost of funds of 2 percent. Then (the) Treasury assigns a cost of funds of 3.5 percent to the indirect lending department. Then the indirect lending department within that bank has to assign their own; they have to build in the cost to run their unit," says Lee Domingue, chief executive officer for Indirect Lending at Wolters Kluwer Financial Services.

"If there is 3 percent, or 300 basis points, that it costs that indirect lending unit to operate, they in turn will assign a dealer buy rate of 6.5 percent," he says.

The operating costs of the bank -- including underwriting, originating, servicing and loan defaults -- go into the cost of funds, and then what's called a rate card is built. "What that does is assign dealer buy rates based upon credit tranches, or credit scores," says Domingue.

Borrowers with the highest credit scores get the best rates. As credit scores go down, risk increases for the lender and loans are priced accordingly. These higher interest rates help the lender cover the cost of loan defaults and the extra investigation and effort required for underwriting loans to people with spotty credit, says Van Leeuwen.

Lenders constantly update their rates to reflect their cost of funds, but they're also pressured by market forces and the need to stay competitive.

According to Domingue, in a rising interest rate environment, lenders can sometimes leave interest rates on car loans untouched. "But they can only do that for a season," he says.

Even lenders affiliated with the automakers that have a vested interest in supporting dealers and manufacturers in making as many sales as possible have to respond to market conditions or risk losing money, says Van Leeuwen.

In the current environment, with the federal funds rate as low as it can go and the FOMC not expected to make any moves in the immediate future, lenders have been responding more to credit risk, which has increased as the market has declined.

"Many lenders have raised their lending criteria," Van Leeuwen says. "What always happens when you have a downturn is lenders become a bit more discriminating. A person that could have gotten financing three years ago is going to find it more difficult today. That doesn't mean it's impossible, but it's just more difficult. You may have to put more money down, the rates may be a bit higher, or you may have to buy a car that creates a lower payment than you did three years ago."

Consumers can't control the economy or the Federal Reserve, but they can control their credit score, and that is often much more important when it comes to getting a good price on a loan.

To save the most money on a car loan, work on raising your credit score as much as possible.

It's not something that can be done overnight, but most people don't make major purchases on a whim either. Pay down debt and pay your bills on time, and that will have a greater impact on the price you pay for an auto loan.

"The moral of the story is to pay your bills on time," Domingue says.

If you're dealing with other money problems, Bankrate can help. Read the Bankrate feature "How to solve 5 money problems."

Auto loan interest rates since December 2008

To find updated auto rates in your area, visit Bankrate's auto rate table.

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