When you borrow money from a lender, your credit score will directly impact your interest rate. Each lender will calculate your rate using a unique formula to estimate the risk of lending money for the lifetime of a loan. Because the risk changes over time, your loan term also influences your rate. By understanding how lenders determine your interest rate, you can optimize your borrowing for easy repayment.

The Purpose of Your Credit Score

Your credit score contains information about your borrowing history, outstanding debt and financial health. Ranging from 300 to 850, credit scores may fall into one of five categories. Super prime ranges from 720 to 850, prime from 660 to 719, nonprime from 620 to 659, subprime from 580 to 619 and deep subprime from 300 to 580. Lenders use these categories to set interest rates, so they typically offer one of five possible rates to borrowers.

Lenders also gauge your financial health by checking your debt-to-income ratio. While your credit score tells lenders about your past borrowing and repayment history, your DTI ratio tells them about your current ability to repay a loan. By paying off your debt and reducing your DTI ratio, you’ll improve your credit score and receive better rates from lenders.

A Breakdown of Interest Rates by Credit Score

Lenders use many methods to calculate interest rates, so rates can vary depending on the lender and type of loan. On average, super prime rates for used car loans come to 4.29%, prime rates to 6.04%, nonprime rates to 11.26%, subprime rates to 17.74% and deep subprime rates to 20.45%. For each monthly payment, the rate is applied to the outstanding balance and used to calculate the ratio of interest to principal. As the balance decreases over a loan’s lifespan, interest fees become a smaller proportion of each payment.

Your credit score isn’t the only factor affecting your interest rate. The risk to lenders increases with the length of the loan term, so interest rates are lower for loans with shorter terms. A larger loan also carries a greater risk to lenders. Subprime borrowers can often reduce their interest rates by increasing their down payment.

How lenders use your credit score to set your interest rate
Other Factors That Influence a Loan’s Cost

You can reduce your interest rate by improving your credit score or choosing a shorter loan term. By borrowing as little as possible, you’ll minimize the cost of your loan no matter what your credit score is. A down payment will reduce the principal of your loan, decreasing its overall cost and the amount you’ll pay in interest. Paying off your loan will gradually reduce your interest charges by decreasing your outstanding balance.

The percentage of your monthly payment that goes toward interest will change over time. Your early payments will include a larger proportion of interest charges than later payments. Near the end of your loan term, your payments could go almost entirely toward repaying the principal. Understanding how lenders schedule interest charges can help you quickly reduce your outstanding balance.

Borrowing With Subprime Credit

You can still get a loan with a credit score under 620. With simple-interest loans, lenders offset the risk of lending by charging interest fees on the loan’s outstanding balance. That way, they can collect the bulk of the interest fees near the beginning of the repayment schedule. Subprime lending works the same way as prime lending but with higher interest rates. Like prime borrowers, subprime borrowers can reduce their costs by minimizing their loan terms and principal amounts.

The key to smart subprime borrowing is saving money upfront while working to improve your credit score. Even with a low credit score, you can optimize your interest charges by minimizing the risk to your lender. By choosing the right vehicle and making the largest down payment you can afford, you’ll keep your interest rates to a minimum.

How lenders use your credit score to set your interest rate
How Lenders Set Your Interest Rate

Lenders use credit scores, loan terms and principals to estimate the risk of lending. Borrowers with high incomes and low DTI ratios pose a low risk to lenders because these borrowers can afford to take on additional debt.

A lender’s main concern is the borrower’s ability to make loan payments on time. Statistically, the risk of missed payments and loan defaults increases with the length of the loan term, so choosing a shorter term will usually reduce your interest rate.

Your Monthly Interest Charges

Once your loan is finalized, you may reduce your monthly interest charges further by paying off your loan early or refinancing. The best way to reduce interest fees in the beginning is by making extra payments. The majority of your interest fees will be charged during the first half of your loan term. Later, your payments will primarily go toward repaying the principal, so making extra payments then won’t save you much money. Instead, you might reduce your later payments by refinancing.

Car Payments for Prime and Subprime Borrowers

Monthly car payments can vary widely between borrowers with equal loan terms and remaining balances. For the same $30,000 auto loan, a deep subprime borrower can pay $174 per month more than a super prime borrower. Therefore, it’s important for subprime borrowers to make a large down payment and choose the shortest loan term they can afford. Prime and super prime borrowers have the luxury of receiving low-cost loans with easy repayment schedules.

How lenders use your credit score to set your interest rate
Reducing Your Monthly Payments and Interest Charges

The best way to minimize your car payments is to borrow as little as possible. By researching vehicles ahead of time and choosing the best option for your budget, you’ll keep your interest charges low and your monthly payments affordable.

Making extra payments can reduce your loan’s cost, but borrowing less money upfront is usually the better option. Typically, prime borrowers can afford to finance more expensive cars than nonprime and subprime borrowers. To reduce their debt burden, subprime borrowers can choose less expensive cars and make larger down payments.

Why Used Cars Cost Less to Finance Than New Cars

Lenders offer low interest rates for new cars, but the overall cost of financing a new car is much higher than financing a used one. The reason is that new cars depreciate significantly during their first year of use, so some borrowers can end up with negative equity on their vehicles. The older a car gets, the less it depreciates. Borrowers benefit from the slower depreciation of a used car, but they pay their lenders a higher interest rate for the risk of driving an older vehicle.

Getting the Best Deal on a Car Loan

Your credit score affects your auto loan’s interest rate more than any other factor. If you’re a subprime borrower, you can save money by raising your credit score before taking out a loan. While it may initially take some time, it could save time in the end by reducing the amount of your income that goes toward repayment.

With a subprime credit score, it makes sense to choose a less expensive car and borrow less to pay for it. As your credit score improves, the vehicles in your price range will become newer and more expensive.

Auto loans are available for borrowers with all kinds of credit, so always aim for a loan with the best terms you can find.