How Does Interest Work on a Car Loan?

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If you borrow money from a lender to finance a vehicle, you will be charged interest on the monthly payments you make toward the loan. Interest is how much you pay per year to borrow money—and it is paid as a percentage, also called an interest rate. 
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How interest is calculated on a car loan

When you take out a loan to finance a car purchase, you’ll have to pay back the principal—the amount of money you were loaned—as well as interest, which is a percentage of the principal. There are two types of interest: simple or precomputed. Most car loans have simple interest. 

Simple interest 

Simple interest loans are front-loaded, which means you pay more interest at the beginning of the loan period than at the end. The monthly interest amount changes based on your loan balance on the day payment is due, meaning that interest decreases as you pay down the principal (the total loan amount). 
When it comes to simple interest, paying more than the amount due each month can decrease interest faster.

Precomputed interest

Precomputed interest is calculated based on how much you’re borrowing at the start of the loan. The interest rate will be the same percentage each month (fixed interest), so even if you pay the loan off early you won’t save much on interest cost. 
Again, this type of interest is very uncommon for car loans—but you should always read your loan agreement thoroughly before signing and ask questions about any terminology you don’t understand. 
Key Takeaway: With simple interest, your interest payments will decrease over time, but precomputed interest requires you to maintain steady interest payments at a fixed rate. 
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What factors impact your car loan interest rate?

Not everyone has the same interest rate, sot it’s worth understanding what determines your interest rate. Here are some factors that determine how much interest you will pay:

Credit Score

A good rule of thumb is: the better the credit score, the lower the interest rate. Interest rates on new car loans for people with good or great credit scores are typically 11% lower than those with low or no credit.  

How much you put toward your down-payment

When you put a larger down-payment toward your car loan, lenders consider you at lower risk for defaulting on your loan at a later time. A low-risk borrower will pay less interest than someone who puts little to no money down.

Length of loan term

Shorter length loans carry a lower interest rate than long-term ones. While long-term loans carry a lower monthly payment, you’ll actually pay less interest over time with a shorter term. Also, because a car’s value depreciates so quickly, those who pay long-term loans run into the risk of owing more money on their loan than their car is worth. 

Type of lender you choose

Credit unions often offer lower interest rates than banks or online lenders. For example, a 48-month new car loan from a bank typically carries an interest rate of around 4.8%. Financing the exact same loan through a credit union will carry an interest rate just over 3%.

New car loans vs. used car loans

New car loans have a lower interest rate than loans for used cars. Although the sticker price for a used car may be cheaper than something brand new, you’ll pay a lot more interest on an older model. In 2020, the average interest rate on a new car loan was 5.61%—compared to 9.65% for a used car. 

Interest rates fluctuate with the economy

In a strong economy, rates increase in order to slow inflation. When the economy is poor, rates drop so that people will be encouraged to spend money.
In 2021, the average interest rate on a 48-month new car loan was 5.21%.

How to lower your car loan interest payments 

Taking on a car loan adds thousands of dollars to the amount you pay, and that’s largely due to interest. And because loans and interest almost always go hand in hand, you should expect to pay a good amount of it when you finance a car. 
But there are several ways to save, and if you are financially able, it’s wise to take advantage of these tips on lowering your interest payments: 

Pay your loan off early

If you have a simple interest loan, making additional, unscheduled payments on your car loan shortens the length of the loan term. As mentioned, a shorter loan means less interest paid overall. 

Make a larger down-payment at the time of purchase

Putting more money up-front toward the loan lowers your interest rate and cuts down on the loan length. This is a good financial strategy to save you money in the long run.

Get preapproved for a loan

Before heading to the dealership, consult a bank or credit union to get preapproved for a loan. With a preapproved loan, you can go to the dealership with your terms already in place—you’ll know exactly how much interest you will pay, so no negotiation with the dealer is needed.

0% APR financing

If you have excellent credit and the auto manufacturer offers it, you may qualify for 0% APR financing. This usually involves having a credit score of 800 or above. As enticing as this sounds, you’ll always benefit from shopping around to find the best loan offers available to you.

Refinancing 

When monthly car payments start to feel like more than you can handle, look into refinancing options. Refinancing is a popular strategy when it comes to lowering your monthly payments—but be advised this will likely come with upfront fees.

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FAQs

To calculate your interest on a car loan, divide your interest rate by the number of monthly payments per year. Multiply that number by the balance of your loan—if it’s the first payment, this figure will be the total amount of the principal.
Getting approved for a 3% interest rate means you have great credit! Typically, those with average to above-average credit scores pay rates between 3% and 4.5%. As mentioned before, the average interest rate for a 48-month car loan in 2021 is 5.21%.
APR stands for annual percentage rate. An APR includes the interest rate as well as any additional loan fees. By law, the APR must be indicated on all loan offers.

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