Spreading the cost of a new car using a finance package is a great way to make getting a better new car much more affordable. One of the most important parts of any finance package, be it for a car or any other purchase, is the interest rate.

At the moment, interest rates are higher than normal. So how will this affect a potential car finance package? Let’s take a look.

What is an interest rate?

The interest rate is the amount you are charged for borrowing money from a finance lender. Charged as a percentage, this is how the finance provider makes their profit from lending to you.

Interest rates are written in a variety of ways, with the most common one being the APR – annual percentage rate. It shows you what percentage of interest you are charged for the amount you have borrowed across the year. The amount you pay will reduce as you repay more of the total owed.

Who sets the interest rate?

The interest rate is set by the finance provider. For many providers, it’s their biggest marketing tool as they use this to attract customers. Others will be specialist lenders who may be less strict with their eligibility criteria so that those with a lower credit score can be approved, in exchange for charging a higher rate of interest.

Interest rates change from company to company and even from product to product, but all of them will be affected by the Bank of England base rate. This interest rate is what the lender will be charged by the Bank of England for the money they borrow to lend to you. This is not driven by profit but by keeping the economy working as best as possible.

What is the Bank of England base rate?

The Bank of England sets the base rate to try and keep inflation at a stable level. That means it is constantly under review and is adjusted to meet targets set up by the Government. When the base rate changes, banks will adjust the amount they set their interest rates at. When it goes up, then the banks will raise their interest rates. When it goes down, the rates will lower.

How it affects car finance packages

When you take out a car finance package, no matter what product you go for, you’ll be charged an interest rate on the amount you borrow. This will be based on your credit score, the amount you want to borrow, and also the lender you choose for your finance package.

Higher interest rates mean you will end up paying more for the car finance package in total, however you are still able to spread the cost across the whole length of the agreement. Monthly payments may be higher, but to counter that you can adjust the repayment period.

So if you don’t mind paying a little more overall but want your monthly payments to stay low, then you can extend. If you don’t want to be charged as much interest and can afford to pay more each month, you can reduce the length of the agreement. A higher deposit will also mean you borrow less and won’t be charged as much interest.

Fixed or variable interest rate?

Some finance packages such as hire purchase have a fixed interest rate. That means it won’t change across the length of the agreement, so what you pay at the start will be the same as what you pay at the end. There are pros and cons of this type of interest rate.

The pros are that you know exactly how much you will have to pay for the entire finance package at the start of the agreement, so can budget your finances with a little more certainty. If the base rate goes up, then you also won’t see any change to the interest rate you are being charged.

The cons are that if the economy improves and interest rates go down, then you won’t benefit from any potential reduction in interest rates being set by finance providers.

How you can get a better interest rate

The biggest factor that affects the interest rate you are charged is your credit score, so it’s always a good idea to know just what state your credit file is in. Before you apply for a finance package, you should take a look at your credit history and see if all the details recorded there are accurate. Mistakes can happen and they will leave you being charged more than you might actually be eligible for.

You can also look at any outstanding debts or issues and see if you can take steps to repair them. You might be able to consolidate debt into a single repayment plan that is easier to manage and pay off, and see where any ‘black marks’ (major issues) will expire from your file.

Another way to get a better interest rate is to look at as wide a panel of lenders as possible to see what’s on offer to you. Make sure you choose a provider who can compare the deals available to you and ensure that they carry out a ‘soft credit search’ as this means you can get quotes without negatively affecting your credit rating.

Is refinancing later an option?

If you take out a finance package with a high rate of interest and then interest rates lower, you could potentially refinance the package for a lower rate of interest. You are unlikely to save money doing this but you might be able to make your monthly repayments lower and more manageable. Make sure you take a look at the total cost of the finance package, not just the interest rate, to ensure that you are going to make the most out of this option.