Bad Credit Car Loans and Interest Rates: What You Need to Know

One of the biggest concerns of customers shopping for bad credit car loans in Edmonton is their credit score. Most Canadians know that a low credit score or limited credit history can impact their chances of securing a traditional car loan. However, fully understanding that impact requires diving deeper and considering details like interest rates and how they work. While the team here at IDrive Canada can help you find a bad credit car loan, it is important to understand the ins and outs of automobile financing.

Understanding Loans: Borrowing Money for Big Purchases

Understanding the basics of an interest rate requires first understanding how an automotive loan works. When you're ready to purchase a vehicle, you have three options: pay cash, finance, or sign a lease. Most people don't have the money to pay cash for a car, or if they do, they aren't willing to drain their savings or emergency funds. Signing a lease isn't ideal for drivers who know they can't stay within the mileage parameters or who are particularly hard on vehicles, leading to excessive wear and tear that can lead to penalties at the end of the lease. That leaves financing as the most popular option.

Financing your purchase means relying on a lender to loan you the money for the car. The lender (a bank, credit union, or another financial institution) looks at your credit score to determine your eligibility and creditworthiness. For example, a high credit score and a strong credit history prove you can responsibly manage your debt. In contrast, a low credit score shows the opposite and signifies you're a greater risk, meaning there's a higher chance that you won't repay the loan.

Think of financing and your credit score like this. Your brother asks to borrow some money to cover his expenses as he looks for a new job. If you know he's not responsible with money, and the likelihood of his finding employment and repaying you in the next few weeks is slim, you will probably refuse because you know what will happen. However, if your brother is responsible and already has a job offer, you will probably give him the money. Since lenders don't know you as well as you know your hypothetical brother, they rely on credit scores to determine if they should lend you money.

There's No Such Thing as Free Money

Lenders assume some risk with every loan, regardless of your credit score. While the risk is significantly lower if an individual has a high credit score, there's always a chance the loan won't be repaid. Lenders acknowledge this risk and benefit from approving the loan by charging interest on the amount borrowed. In other words, interest is the fee for the proverbial "IOU." How large this fee is will depend on your credit score.

The Bank of Canada sets what's known as the "prime rate," which is the interest rate for one-day loans between Canada's largest financial institutions. The prime rate is a baseline for other interest rates, determining how much lenders charge on automotive loans, mortgages, and other lines of credit. The Bank of Canada determines the prime rate based on inflation, the demand for loans in relation to available capital, and other economic factors. With the prime rate established, banks and other financial institutions set their interest rates accordingly. These rates are typically based on four main factors: risk, duration, inflation, and demand.

Risk

The first factor is the risk the lender takes with the loan. In other words, the likelihood the borrower will repay the debt. To determine the risk, lenders look at a borrower's credit score and credit history. For example, a high credit score signifies a lower risk to the lender, resulting in a lower interest rate. Alternatively, the lower the credit score, the higher the risk and the higher the interest rate.

Duration

The second factor looks at the duration of the loan because risk increases with time. Why? Your ability to repay a loan likely won't change within a few months or a year, making short-term loans less risky for lenders. However, financial situations can change dramatically over several years, making longer-term loans riskier for the lender. As a result, you will generally pay a higher interest rate the longer the loan you take out.

Inflation

The interest rate on your loan is also affected by inflation and demand. Inflation is a critical consideration for lenders because it looks at the value of the money borrowed in terms of the future. If inflation is higher than the loan's interest rate, the lender is effectively losing money on the loan. While lenders can't predict future inflation, they can look at economic trends and the Bank of Canada's prime rate. Although the prime rate only impacts loans made to chartered banks, it shows where interest rates are headed. For example, when the Bank of Canada increases its prime rate because of inflation, lenders adjust their rates accordingly.

Demand

Along with attempting to predict inflation, lenders also look at the demand for borrowed money and other economic factors when determining interest rates. For example, during a recession, people are less interested in borrowing money and, instead, do everything they can to save. Lenders respond by lowering interest rates to entice people to buy and boost the economy. Then, as the economy recovers, interest rates slowly climb. During this time, businesses raise rates in response to consumers applying for lines of credit and buying everything from cars and homes to entertainment systems, furniture, and other higher-priced items.

How Interest Rates Apply to Bad Credit Car Loans

Now that you understand interest rates and how they work in Canada's vast financial landscape, how does that knowledge apply to bad credit car loans and your efforts to find a reliable vehicle you can afford here in Edmonton? It all comes back to risk and your three-digit credit score. What do we mean?

Your credit score determines your creditworthiness and is how a lender evaluates the risk associated with the loan. While every lender determines what scores they deem acceptable, Edmonton lenders that offer traditional automotive loans generally won't work with individuals who have bad credit. They consider the risk far too great, leaving such loans to specialized bad credit lenders.

Like other loans, the interest on a bad credit car loan is affected by your credit score, financial situation, loan needs, the duration of the loan, and other factors. Since there is a higher risk, most bad credit car loans mitigate that risk by charging a higher interest rate. For example, you may pay a 20% interest rate on a bad credit car loan instead of a 7% interest rate on a traditional loan with an excellent credit score. However, at IDrive Canada, we will work to get you the lowest rate possible.

Although the higher interest rate of a bad credit loan means spending more on your purchase over time, the expense is often worthwhile. Why? A bad credit car loan can help you break the cycle and rebuild your credit one payment at a time. As you make your monthly payments on time and in full, your credit score will slowly increase, rebuilding your credit history and creditworthiness and setting you up for future financial success.