Budgeting Loans

How Does Interest Work On a Car?

Purchasing a new car is a big financial decision, one that requires a significant amount of research. It’s always a good idea to gather all the information available on a topic before spending a large amount of money. 

When buying a car, it is likely you might be relying on a car loan rather than purchasing it outright. This will mean that you’ll be charged interest throughout the life of the loan until it is repaid in full. You will want to have an in-depth understanding of how interest rates on a car loan work before signing any kind of contract agreement.

What Is An Auto Loan?

Auto loans are one of the most common ways of purchasing a vehicle for middle-class Americans. The average person does not have enough money to buy their car outright, so they get an auto loan. Car loans are loans with monthly installments used for the express purpose of buying a car. 

The loan terms are set so that the loan balance plus interest is repaid within a specific period of time, typically between one and five years. Like mortgages, auto loans are a type of secured loan in which the equity of the car you buy is used as collateral. This means that if you repeatedly don’t make your monthly payments and default on the loan, your car could be repossessed by the lender. 

How Does Interest On Car Loans Work?

Every car loan will have an interest rate. Car loan interest can be thought of as the cost you pay to borrow money so that you can purchase the vehicle. Lenders need to be paid for their services somehow, and a loan’s interest rate is the primary way they make a profit. 

However, the interest rate means that the amount you pay on your car loan will not equate to the price of the car. When repaying the auto loan, you need to pay the loan balance in full plus the interest that is accrued over the duration of the loan term.

How Is Interest Calculated?

Determining how your car loan interest is calculated might help you better understand how car loan interest works. How your car loan interest is calculated depends upon what type of interest rate you have on your loan. The percentage is not the only aspect of an interest rate that matters, but when and how often it is applied to the loan balance. 

The two most common types of interest rates used for car loans are simple interest and precomputed interest. 

Simple Interest Loan

Most car loans are simple interest car loans. A simple interest loan has an annual percentage rate that is applied to the loan balance as it stands when each monthly payment is due. This means that the total interest paid can decrease if the loan is paid off earlier than the loan term dictates.

Simple interest loans have an amortization schedule, meaning each loan payment goes towards the loan amount and interest charges. You should be able to calculate the total amount of interest you will likely pay on the car loan if you follow the scheduled monthly payments by using the interest rate, the loan length, and the loan amount. 

Precomputed Interest Loan

Some auto loans have precomputed interest instead, which means that the interest is calculated upfront based on the loan amount. The interest charges will be added to the loan balance according to the loan term and will not change depending on how quickly you pay off the car loan. 

The monthly payments are not amortized on a precomputed interest loan, meaning that each car payment is not applied separately to both the interest and the balance. It is not as easy to decrease how much interest you pay with precomputed interest as it is with simple interest.

What Is the Average Interest Rate On Car Loans?

The average interest rate for a car loan in 2021 was an APR between 4% and 6%, with a wide range below and above depending on various factors. The average interest rates you receive when rate shopping for a car loan can vary depending on where you live, the overall market conditions at the time, and what lender you are looking to borrow money from. 

Factors That Impact Interest Rates on Auto Loans

Here are a few other factors that will affect the interest rate you might get on an auto loan:

Your Credit Score

People with the highest credit scores are more likely to receive lower interest rates on car loans. If you have a poor credit score, you will probably get a higher interest rate on your car loan. You might even struggle to be approved for an auto loan in the first place if your credit score is bad enough. 

The Down Payment

Lenders tend to charge a higher interest rate on an auto loan with little to no down payment. The risk associated with the loan increases for the lender the less money they receive in a down payment. Because of this, the lender will often increase the interest rate of the auto loan. 

Your Loan Term Length

The interest rates tend to be higher on car loans with longer loan terms. A longer loan term will give you lower monthly payments, but it will likely mean you pay more on interest charges. Vehicles depreciate exceptionally quickly, so the longer the loan term, the more money you are paying over the actual value of the car.

How To Minimize Interest Charges On Your Car Loan

If you want to save money on interest charges on your car loan, there are a couple of things you can do before obtaining a new car loan so you get a better interest rate. But there are also several things you can do to reduce the total interest you pay on an existing car loan. 

Paying Early

If you have a simple interest rate on your car loan, you could save a significant amount of money in interest charges by paying off your loan early. When you have simple interest and amortization, making unscheduled payments and regularly paying more than the minimum payment will allow you to significantly reduce the amount of interest you pay. 

Excellent Credit

If you are planning to apply for a car loan soon, you can improve your chances of getting a reasonable interest rate by boosting your credit score ahead of time. Doing a few simple things to increase your credit scores before applying for your loan can ensure you get the best car loan available with lower interest rates. 

Short Loan Terms

You might be hesitant to choose shorter loan terms because of the higher monthly payment. But choosing shorter terms, you could access lower interest rates on your auto loan. In addition to being offered lower interest rates, you will end up paying less interest because you’ll have fewer monthly payments. 

Refinancing

If market conditions change part way through the life of the loan, refinancing your car loan could get you a more affordable interest rate for the remainder of your loan amount. Refinancing your auto loan could also be beneficial if your credit score has significantly improved since when you first obtained the loan. 

References:
How Does Car Loan Interest Work? – Tresl Auto Finance