How Does Car Loan Interest Work?

Whenever you borrow, you have to pay for that privilege. And as you no doubt know, the way you pay is with interest. Car loans, like other types of credit, come with interest payments. But there are some different differences between car loan interest versus other types of interest – such as mortgages, credit cards, student loans, etc. Below I’ll explain how car loan interest works.

Car Loans Use Simple Interest, Not Compound Interest

Unlike some other types of loans, many car loans charge you simple interest, rather than compound interest. Whereas compound interest accrues on your principal and on the interest that accumulates, simple interest only accrues on your principal.

Since you only pay interest on the principal when your loan uses simple interest, you end up paying less than if it was compound interest. As an example, say you get a loan for $10,000, and you pay it off over the course of five years (60 months), which is pretty typical for an auto loan. The interest rate is 5%. Here is what your final cost (principal plus interest) would be with:

Compound interest (compounding monthly): $12,833.59

Simple interest: $11,322.74

Just by avoiding paying interest on your interest, you can save more than $1,500 over the life of this loan. However, that doesn’t necessarily mean you should get a car loan! There are more factors to consider, such as amortization.

Car Loans Use Amortization

Car loans use the principle of amortization, similar to the way a home loan is paid down. This means that at the outset of your loan, a greater amount of your payment goes toward paying the interest on your loan, and less goes toward paying down your principal.

As the loan term progresses, though, the balance shifts. More and more of your payment goes toward principal at the end of the loan.

One way you can save a little bit more on your car loan interest is by making extra principal payments at the beginning of the loan. Since the simple interest is calculated on the remaining principal periodically, you can reduce the amount of interest that you pay overall by putting extra money toward the principal.

In order to do this most effectively, it can help to make an extra principal payment each month or set up biweekly payments. Find out from your lender how best to do this. Many lenders like you to make the payment separately from your scheduled payment. The extra payment should be designated as a principal payment in order for it to have best effect. Then, the next time the interest on your principal is calculated, you will be charged less interest. You can pay off your car loan faster, and save money, by making extra principal payments.

Getting a Good Deal on Your Car Loan Interest

If you want to get a good deal on your car loan interest, it’s important for you to plan ahead. Some of the ways to ensure a lower interest rate on your auto loan include:

Boost your credit: Almost anyone can get a car loan from a dealer. However, if you have bad credit, you will pay in the form of a higher interest rate. If you want the best possible interest rate, you need improve your credit. Take a few months before you buy your car to actively work on improving your credit.

Make a down payment: A bigger down payment means that you borrow less. The less you borrow, the smaller the amount that you pay interest on. Plus, many lenders are willing to give you a lower interest rate, since the fact that you have “skin in the game” reduces the amount of risk they have to take on.

Look for deals if buying new: While it’s often better to buy a used car, if you are planning to buy a new car you should know that it can come with lower interest rates and/or incentives for discounted rates. As long as you are prepared for the inevitable value drop as you drive it off the lot (personally, I don’t care because we don’t sell our cars; we drive them until the give up the ghost) then you’ll be fine.

Car loan interest adds to the cost of your car so if you can, it makes sense to buy with cash and avoid the interest altogether. But, if that isn’t an option, car loan interest isn’t the worst thing in the world.

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