How Does Interest Work On a Car Loan

Interest is the main cost when borrowing money. It is tacked onto the principal amount, which is the amount you get from the loan. Usually, with a car loan, the interest rate is charged as a percentage of the principal amount (the APR) and then broken down into monthly payments. 

Interest helps mitigate the risk for the creditor associated with lending money. While not ideal for the borrower, interest means getting the funds they need upfront so they can make their purchase. 

If you are a borrower thinking about a car loan, it’s important to consider the interest rate. Interest plays a key role in the monthly payment of your loan and the overall cost. The amount of interest you will pay on a car loan will depend on the lender you work with and your finances. 

How Do Car Loans Work?

A car loan is a type of secured loan; in this case, the vehicle being financed is the security with this transaction. 

There are a few legal considerations that you should be mindful of when taking out a car loan. The first one to keep in mind is that the lender will legally own the vehicle until the loan is repaid in full. This ownership will be apparent via a lien on the car’s title. A lien will prevent you from selling or trading your vehicle until the lender is repaid. 

Secondly, you should know that the loan term that you enter with a lender will be a legally binding contract. Once you take out your car loan, you’ll likely have to begin repayment about a month afterward. After those payments start, you’ll have to make make a monthly payment until the loan balance is repaid in full. It’s extremely important to consider your loan terms and the monthly payments because several missed payments on your car could mean repossession from your lender. 

One last thing to know about car loans is that they may have additional costs aside from interest rates:

• A Down Payment — A down payment is money you put down for the car, which reduces the amount of the car loan that you are borrowing. It can help lower your monthly payments.

• Loan Fees — Built-in fees such as an origination fee and application fee. 

• Late Fees — If you make a late payment, you will likely have to pay a late fee alongside your standard monthly payment. Late fees vary from one lender to another. 

• Insurance Costs — Car loans often require car insurance; you’ll have to factor in that cost as well. Comparing insurance providers is pretty similar to comparing lenders, shop around and compare rates and coverage details. 

• Early Repayment Fees — In some cases, you may have to pay extra fees if you want to repay the loan early. 

• Extended Warranties and Add-ons — Any additional warranties you want for the vehicle or additional add-ons like accessories or features. 

What Is a Car Loan Interest Rate?

The interest rate is the amount you will pay when borrowing your auto loan. It is a percentage of the principal loan amount. Interest can be calculated on a yearly basis (also called the annual percentage rate/APR) and on a monthly basis, which is the amount that you pay every month. 

There are two primary ways to calculate interest: simple interest and compound interest. Simple interest is the most common type of interest rate. It is calculated based on the principal amount only, while compound interest is calculated based on both the accumulated interest and the principal amount.

The interest rate on auto loans is typically calculated as simple interest. Of course, your specific rate will depend on the lender you work with and your finances. We’ll discuss those details a little more below.

Types of Car Loan Interest Rates

When it comes to interest rates, there are two that you should know about, which can vary with car loans: variable interest rates and fixed interest rates. Variable interest can change throughout the loan term, depending on market conditions and a few other factors. While fixed interest rates stay the same throughout the loan agreement and monthly payments. 

Both interest rate types have pros and cons. With variable interest rates, your interest rates may become lower as you repay your loan balance; however, on the flip side, that interest rate fluctuation could also be higher. With fixed interest, you get interest rate stability; however, you may miss out on potential savings. 

How is Car Loan Interest Calculated?

As we mentioned earlier, car loans usually have simple interest rates / are simple interest loans. 

To calculate simple interest, you can use the following formula:

Interest = P × r × t, where;

P = Principal amount 

r = Annual interest rate (expressed as a decimal)

T = time the length of the loan term (expressed in years based on your loan repayment schedule)

Here is a step-by-step example that can help you if you want to use this formula to calculate your interest on your auto loan:

Let’s say you are planning on borrowing a $10,000 loan where the APR is 7%, and you’ll have a 32-month financing plan. Here is how you would use the formula for total interest computation:

1. Let’s first express the annual percentage rate into a decimal:  7%=1007​=0.07. So, 7% as a decimal is 0.07.
2. Next, let’s express 32 months into years, which is three years. 
3. Now, you can plug that information into a formula: Interest = 10,000 x 0.07 x 3. Interest=2,100

Therefore, the interest cost for the auto loan will be $2,100. 

This formula is one option you can use; however, there are online loan calculators that can do this work for you! Your lender should also be able to give you these figures when asked. 

Factors Affecting Car Loan Interest Rates

There are lots of factors that influence interest rates with auto loans; here are some of them:

• Credit Score — Your credit score and creditworthiness will play a large role in your auto loan interest rate. The higher your credit score, the more financial stability you show to lenders, and the lower interest rate you may get. A lower credit score will mean potential risk for the lender, and so the interest rates will be higher. 

• The Loan Amount/Loan Balance — A larger car loan usually comes with a higher interest rate. The loan-to-value ratio (which compares the loan balance to the value of the vehicle) will also impact interest. When this is higher, your interest rate will also be higher. A larger down payment can lower the loan-to-value ratio, decreasing your interest rate.

• The Loan Term — Usually, when an auto loan is longer (e.g., 60 or 72 months), the average interest rate will be higher than a shorter term (e.g., 12 to 32 months). This is because a longer loan term may pose a higher risk of default. 

• Lender’s Policies — Every auto lender may work a little differently depending on the lender’s policies. Some lenders may have a higher base interest rate than others, and rates can vary quite a bit. This is why shopping around is so essential when considering an auto loan. 

Impact of Credit Score on Car Loan Interest

Credit scores go hand in hand with most kinds of lending (for both eligibility and interest rates), including auto loan interest rates. The better your credit score, the better your average interest rate will be across the board. And why is that important? Well, the bottom line is that lower interest rates will mean saving money. Not only that, but they can also mean a lower monthly payment and make a loan more manageable. 

The main credit score used for consumers is the FICO score, followed by the VantageScore. These scores are built through actions with your credit accounts, which are reported to the three major credit bureaus: Experian, Transunion, and Equifax. You can get your credit information by requesting your credit report from each of them. 

Here are the credit score ranges for FICO scores:

• Exceptional: 800–850
• Very Good: 740–799
• Good: 670–739
• Fair: 580–669
• Poor: 300–579

And here are the ranges for VantageScores:

• Excellent: 781–850
• Good: 661–780
• Fair: 601–660
• Poor: 500–600
• Very Poor: 300–499

If you don’t have the best credit history or score, the good news is that you can work on improving it! 

Here are some credit improvement strategies that you can use if you are trying to build your credit score. They may help you secure better rates on auto loans:

• Make Your Credit Payments on Time — One of the best things you can do for your credit scores is to pay your bills on time, specifically your credit accounts. Your payment history is the largest factor that impacts your scores, so even one missed monthly payment can be damaging to your credit.

• Reduce your Debt — Debt impacts many different factors in your credit scores, including credit utilization. By reducing your debt, you can decrease your credit utilization and help your score. Less debt also helps with things like paying your bills on time. 
• Limit New Credit Inquiries — Hard credit inquiries can bring down your credit score a few points, so it will be helpful to space them out. 

• Keep Your Revolving Credit Accounts Open — Keeping revolving accounts like credit cards open., even after paying them off, will help your credit scores. 

• Check Your Credit Reports Often — It’s important to monitor your credit reports often to look for errors or inconsistencies, as they can hurt your scores. Be sure to correct them right away. 

Negotiating Better Car Loan Interest Rates

Negotiation with lenders is always worth a shot because it could mean less interest! Here are some strategies that you can use for negotiating interest to save money:

• Do Some Comparisons and Use Them As Leverage — You can ask around for estimates from several lenders and even apply for preapproval; once you have that, you may be able to use those estimates to secure a lower interest rate,

• Ask Your Lender for Discounts — Some lenders may have discounts for military members, teachers, seniors, or new customers. Definitely ask about these!

• Negotiate Factors that Also Impace the Cost of Your Loan — If you are unable to lower your interest payment, it may be worthwhile to try to negate other terms, such as the loan term and other fees and charges. 

Need to Pay Off Your Car Loan? Consider CreditNinja 

Interest is an essential component of any loan, including auto loans. They add protection for the lender and allow consumers to afford the purchase of a vehicle. Usually, an auto loan is a simple interest loan, which is one way that interest is calculated. Calculating this before you choose a loan can be helpful! Several factors impact interest rates with an auto loan, and with that information in mind, you can move forward with the right choice for you. One thing to keep in mind is that just because you will have to pay interest, it doesn’t mean that can’t negotiate! It is always worth a shot to negotiate for less interest if you can do so. 

If you currently have a car loan that you need to pay off, CreditNinja’s personal loan options may be exactly what you are looking for! Our personal loan options are fast, convenient, and made to help with these kinds of costs. Check us out for a potential solution to get through your car loan!