Interest rates

Lessons from the past point to the future of interest rates for new used vehicle customers

It’s been over 45 years since we last took free-market economist Vervon Orval Watts’ economics course at Northwood University. He noted that an interest rate is the incentive or reward charged by a credit or money lender. For the borrower, it is the amount he is willing to part with or pay for money or credit.

An interest rate consists of three parts. These are the time preference premium, the debtor risk premium and the inflationary risk premium.

The time preference premium is the original reason for lending money. The average TPP portion of an interest rate is between 0 and 2%. It represents a borrower’s time preference to have a good, service, or asset today and pay extra through the interest rate, rather than waiting until they can pay in full. When a time preference is 0%, the borrower is willing to wait.

The debtor risk premium is inversely proportional to the solvency of the customer. The debtor’s risk premium portion of an interest rate typically ranges from one-half percent to infinity. A person with a high overall credit score generally receives a low DRP, while a person with a low credit score receives a high DRP, resulting in a higher interest rate on future loans. Fraud and other criminal activities also increase the DRP.

The inflationary risk premium is correlated to the inflation rate. As inflation increases, the IRP portion of an interest rate increases, as does the overall interest rate. When inflation decreases, the PIR and the overall interest rate also decrease. The PIR, in theory, is between 0% and infinity. Prior to 2021, 30-year mortgage interest rates were below 4% and auto loans for those with low DRPs were at or near 0%.