How interest on car loans works

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In a Nutshell

Not understanding the nuts and bolts of interest on your car loan could lead to expensive mistakes. How your car loan interest is calculated, your credit and the length of your loan are among the factors that might drive up the total amount you pay in interest.

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You may consider features like gas mileage, paint color, roominess and high-tech accessories when shopping for a car. But once you’ve settled on a make and model, how much do you think about the nitty-gritty details of the car loan’s interest?

Before you take out a car loan and drive off the lot, take time to understand your interest rate and the factors that affect it — it could save you money. Here’s what you should know.


There are two types of interest rates

You may see your car loan’s interest rate listed two different ways in your loan contract.

The interest rate is the amount you pay each year to borrow money, and it’s shown as a percentage. This base interest rate doesn’t include any loan fees.

The annual percentage rate, on the other hand, reflects the total amount you pay each year to borrow money, including the interest and fees you pay to get the loan. A higher APR means more money will come out of your pocket until you pay off the loan in full.

All lenders are required to disclose the APR on a loan offer. So when comparing loans, look at the APRs, which reflect the total financing cost. And make sure you’re comparing apples to apples, or APR to APR, rather than APR to interest.

Car loan interest is front-loaded

Car loans are amortized, which means the interest is front-loaded.

When a loan is amortized, part of each monthly payment goes toward the amount of the money you borrowed (the principal), and the other part goes toward the cost of borrowing (the interest).

In the first few years of your loan, more of your monthly payment is allocated toward the interest. Toward the end of the loan, a bigger portion of your monthly payment is applied to the principal.

For example: If you had a five-year $30,000 car loan with a 4.5% interest rate, and you made all your scheduled payments, you’d pay $113 in interest in the first month and only $2 in interest in the last month of the loan.

Paying more in interest and less toward principal in the first few years means you’ll have a lower percentage of equity in the car early in the loan. Keep this in mind if you plan to sell or trade in the car within a couple years. Depending on the down payment you made and the length of your loan, you may find that you owe more on your loan than the car is worth.

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Various factors influence your car loan interest rate

A lender weighs several factors when determining the interest rate for your auto loan. These may include …

  • Your credit scores and credit history — Generally, the lower your credit scores, the higher your car loan’s interest rate will be.
  • The loan term Loans paid over a longer time period typically come with higher interest rates. The higher rates can help your lender reduce its risk by getting more money back through interest.
  • Your down payment — Your loan-to-value ratio — the amount you borrow versus the car’s value — can affect your interest rate. If you make a small down payment, or no down payment at all, your lender takes on more risk, which will likely result in a higher interest rate.
  • Whether the car you’re buying is new or used — Used-car loans tend to have higher interest rates than new-car loans, one reason being that used cars can have a lower resale value. The lender may charge a higher interest rate in case you default on the loan and it needs to sell your car.

FAST FACTS

Can I negotiate my interest rate?

You can try, but keep in mind that dealers and lenders are under no obligation to give you the best rate. Getting preapproved for financing might give you more leverage. When a lender gives you a preapproval, it is giving you a quote of what your interest rate, loan length and loan amount could be. While it is important to remember this is not a guarantee, getting multiple preapprovals may help you identify the lowest available rate for you.

Your car loan can have simple or precomputed interest

When you’re shopping for a car loan, the interest rate can be calculated in two ways: simple or precomputed.

With a simple interest loan, the interest is based on the balance you owe on the day your car loan payment is due. If you pay more than the amount due, your loan balance should decrease — and the total interest you’ll pay on the loan can, too.

With a precomputed loan, the interest you owe on the entire loan is calculated in advance. This can make it more difficult to pay your loan off early, because the interest you end up paying won’t decrease as it can with simple interest.

If you plan to make more than the minimum monthly payment or pay off your car loan early, a simple interest loan with no prepayment penalties is likely a better option. Be sure to ask potential lenders which interest calculation method they use.


Bottom line

A number of factors influence the amount of interest you pay over the life of a car loan. Improving your credit, saving for a down payment and making sure you understand your loan’s interest calculation method are just a few of the ways you could ultimately save money in the long run.

Remember, too, that your interest rate is just one part of your loan. It’s important to understand all the terms of a car loan so that you can accurately compare offers and get the best deal for you.

Understanding a car loan