Auto Loan Interest Rates

What influences your auto loan interest rate?

Your auto loan interest rates are influenced by your credit history, current finance rates, competition, market conditions and special offers.

Interest Rates and Loanable Funds

The loanable funds theory is commonly used to explain interest rates. While this is helpful, it is not perfect. The basic idea is that supply of loanable funds must equal the demand for loanable funds or else the interest rates will change.

Many factors influence both the supply and demand for loanable funds. Loanable funds theory is based on premise of supply and demand. Much of this should be quite intuitive. If the demand for a good goes up, so too does the price (ceteris paribus).

Aggregate Demand for Loanable Funds

Aggregate demand for loanable funds can be segmented into several main parts:

1. Household demand
2. Business Demand
3. Government demand
4. Foreign demand

1. Household demand for loanable funds: Although usually households are the net providers of loanable funds, they also are in the market as borrowers. As such they demand funds in many ways: mortgages, credit card debt, auto loans etc. Generally speaking demand picks up as the economy picks up. Moreover as we all know demand curves slope down so as interest rates increase, the quantity demanded goes down. Note this does not change the demand curve, only the position in the demand curve.

2. Business Demand for loanable funds: This can be long-term borrowing for capital projects or short term financing of inventories and other short-term assets. Like Household demand, this is usually positively correlated with the economy.

3. Government Demand for loanable funds: Government borrowing is often a major determinant of interest rates. Government spending /borrowing is largely interest-inelastic. That means it is not largely a function of prevailing interest rates. Government borrowing is more a function of spending (which may run counter to the economy), and government revenues (which are positively correlated with the economy).

4. Foreign Demand for Loanable Funds: Demand fluctuates with the real rate of interest. This is becoming more of a factor as the world becomes increasingly global.

Supply of Loanable Funds

Households are the largest suppliers of Loanable Funds, but by no means the only source. Businesses and Government also can be temporary suppliers of loanable funds. It should be no surprise that as interest rates rise suppliers are more willing to supply funds. Internationally, Japan, the UK, and Germany have been large suppliers of funds to the US. This is partially the result of a higher propensity to save in these countries. (Example exhibit 2.7 shows US personal savings rate is 5.4% of disposable income vs. 22.3% in Japan.)

Equilibrium Interest rate

The equilibrium interest rate is that rate where the supply of loanable funds equals the demand for loanable funds.

Fisher Effect

Nominal interest rate = Real Interest rate plus expected inflation. The real rate is what matters. Thus if inflation is higher than expected, the lenders lose. (and vice versa).

Key issues

1. Inflation (actually expected inflation) leads to an increased demand and reduced supply for loanable funds, thus interest rates rise.

2. Budget deficits increase demand for loanable funds and hence lead to higher interest rates. (note: key assumption here is ceteris paribus assumption!)

3. Foreign flows of funds can influence interest rates. For example, Japan recession led to lower Japanese rates, thus investors supplied funds to the US rather than Japan. Of course this drove down US rates.

History of Interest Rates

Looking at the 1900s, it can be shown that interest rates have become more volatile in the past 20 years. This is in part due to increased global flows as well as the end of fixed exchange rates. Forecasting interest rates is extremely difficult. Most research suggests that the market is efficient in the sense that it is hard to "beat" the market.