How Does Interest Work on a Car Loan? [ANSWERED]

When you get a car loan, the lender will charge you interest. Take a closer look at how that interest works before you get your loan.

When you borrow money via an auto loan, you will be charged interest, just like you would with any other type of loan. The interest is a small percentage fee applied to your total balance owed. It is essentially the cost of borrowing money from a lender.

Take a closer look at how interest works on car loans, as well as some of the most important factors affecting what you pay and example calculations to help you save.

Car Loan Interest: What to Know

Besides buying a house, a car purchase is likely one of the most expensive purchases a person makes over a lifetime. Many people get new vehicles regularly, even though many do not have the money to pay for one outright. This is why there is financing through loans and why we are discussing interest. Some loans are through an outside lender, while others come right from the automaker.

Before you put your signature on a contract, you should understand how interest works. You can opt to extend your loan over a longer period and lower rates, but how do you know if it is a good deal? Here are a few things to consider.

The Most Important Points

Before going into more details, there are a few important things every car buyer should know about auto loan interest.

Auto loan interest is calculated using simple, not compound, interest. This means you won't have interest on your interest.
Car loan interest is often heavier at the front. This means in the beginning months; you pay more toward the interest than on the principal balance.
Stretching your loan over a longer period will make a lower monthly installment, but you will pay more interest over the life of the loan.
Those with higher credit scores tend to get better loans offered to them with better interest rates.
Shopping loans between lenders and finance departments of auto manufacturers takes effort but can have rewards.

Important Things to Know About Car Loans

The average car price is up 11.4%, at $48,085. With that kind of price, it shouldn't be a shock to know that most finance their car purchases and are choosing loans with longer terms. On average, an auto loan lasts about 70 months.

Remember that interest rates change daily and can vary greatly. Before you start shopping, check what current auto loans go for. You can also consider getting pre-approval from a credit union or bank before shopping. There are consumer reports that suggest car salespeople will give you a good price on cars or financing, but not both. In either case, be informed for the best loan deal.

Car loans include simple interest instead of compound interest. This is good for the borrower because they pay a flat rate on what the principal is. For reference, with compound interest, interest accrues over time, and interest on the interest accrues.

Auto lenders use the term amortized. This means like a mortgage, interest owed gets paid in the beginning payments. If you do not make a large down payment or trade-in, you could be paying "underwater" for some time. This is because car value depreciates once it leaves the lot.

How Does Car Interest Work?

Lenders figure interest on car loans with one of two methods. They may precompute or use a simple interest method. Simple interest is calculated based on the loan price and the due date of payment. Precomputed interest is calculated based on the start of the loan and the total loan amount. The amount paid each month stays the same.

How Is Car Loan Interest Calculated?

The following examples help you understand how interest is calculated and what factors have the biggest impact on your payments.

An Example Highlighting the Impact of a Loan Life

Consider the following figures for this example.

Original Price: $45,031
Down Payment of 10%: $4,503
Amount financed: $40,528

4% Interest on a 5-year Loan

Your balance of $40,528 will be paid off over 5 years at 4% interest. Monthly, you will pay about $746.38. You will pay a total of $44,783.09, which includes $4,255.09 in interest. With the down payment included, the total cost of the car runs $49,286.09.

4% Interest on an 8-year Loan

With the above figures, you would be making a monthly payment of about $494.01 for a total of $47,424.67, which includes $6,896.67 in interest. With your initial down payment, you will have paid $51,927.67 for the loan in total.

This example highlights that while your monthly payment may be smaller with a longer loan life, the amount you end up paying will be significantly higher.

An Example Highlighting the Impact of Interest Rate

Your interest rate will also have a dramatic impact on what you end up paying. Adjust the above figures slightly to a 5-year loan with 6% interest.

When you change the interest rate, watch what your numbers do. With a 6% interest, you will see the following changes.

Original Car Price: $45,031
Down Payment of 10%: $4,503
Amount Financed After Payment: $40,528

After making a down payment, the balance is financed. The monthly payment ends up being $783.52, with a total paid of $47,011.19, which includes $6,483.19. With the down payment included, there is a total of $51,514.19 paid.

An 8-year Loan With 6% Interest

With the above numbers, you will see the longer life loan makes a difference as well. Your monthly payment will be $532.60, and the total paid will be $51,129.20. Of this, $10,601.20 is interest paid. When your down payment is included, that car costs $55,632.20 in total.

What Can Impact Interest

Many factors will affect your interest rate. The good news is that you have control over many of these factors. You can shop with more information if you know a little about interest rates. A knowledgeable shopper is a competitive shopper.

Current Interest Rates

With strong economies, you tend to see higher interest rates. In weaker economies, you see lower rates. If your potential rates are high, consider waiting until they drop.

Credit Scores

An attractive credit score tends to attract better interest rates and lenders. People with lower credit scores will have a harder time getting a competitive rate.

Down Payments

The larger the down payment you can come up with, the better your rate will be. The more you put down, the lower the risk. Smaller down payments may get higher interest rates because of the inherent risk.

Loan Terms

Rates vary depending on the lenders' terms. Longer-lived loans may have higher interest rates.

Type of Lender

Who you choose as a lender can affect your rates. When you go with a credit union, you tend to get competitive rates over bank rates. Comparing lenders before settling on one can save you money on interest.

Used or New Cars

Whether you are buying a new or used car will affect the interest rate you pay. Rates on loans for used cars tend to cost more than those for newer cars. Again, this is because of the risk factored into the loan.

Tips for Lowered Interest Rates

There are several tips that can help you get a lowered rate. Consider the following.

Choose the Right Purchase Time

If the economy is strong and running well, it may be time to wait. When the economy calms down, you may find better-priced cars and lower rates.

Comparison Shop

As mentioned, do not hesitate to compare your lenders. There are many that offer limited deals or have great rates. Consider a few lenders before settling.

Refinance

If you have a high rate, consider taking the opportunity to refinance your auto loan and get a better rate.

Get a Shorter Loan

Another good way to save some money is to not stretch it out over more months. We have shown you above how much this can cost you. So, be aware and keep it short when possible.

Improve Your Credit Score

One of the best ways to save money is to take the time to increase your credit score. There are a few ways to do this, but the most effective is to pay bills on time.

Buy a Cheaper Car

Be realistic about your car purchases and do not push what you can afford. Instead of considering what everyone else is driving, consider what you need and keep to that.

Conclusion

When you take on a car loan, your interest is what you pay to get to borrow money from an institution. You have to repay the amount that you borrowed and additional interest monthly over the duration of the loan. There are a variety of facts that influence your rate, including your credit scores, the size of your down payment, the loan term, and your credit history.

Interest charges are included in your loan payment every month. These can add thousands of dollars to the total you must repay. For this reason, it is important to understand how the interest is factored in and what you can do to minimize your rate.