How Does Car Loan Interest Work?

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.

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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. At least it’s likely to be simple interest, and the rates are usually much lower than credit card interest rates. Just make sure to read the fine print and know exactly what you are getting yourself into. By understanding how car loan interest works, you can save yourself a lot of money in the long run! (And remember, ReadyForZero can help you pay off your debt as fast as possible)

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  • Thanks for sharing this useful info on how car interest rates work, very useful.

    • Thanks! Glad you found it helpful.

    • Vivian F.

      Usually those that are just making ends meet, seem to buy the cars they can least afford. Car salesmen have mastered how to target these vulnerable people. Don’t be one of them!

      The debt spiral is not for me, and I prefer living a life not owing anyone anything. I’m just gonna make smart decisions with my money so I don’t end up with an empty bank account:

      1) Paying off my debts as they come to me. Never holding a credit card balance longer than a month. If this means living in a small studio apartment and eating ramen, rice, and beans, so be it.

      2) I will always buy small, fuel efficient and durable cars. I drive a 2006 Honda Civic now. It costs me nothing to fill up and next to nothing to insure ($24/month from Insurance Panda… woohoo!). I will not drive when I don’t need to, and use public transportation whenever possible.

      3) Developing multiple revenue streams. Doing side jobs. Building up small businesses. Doing contract work. Basically doing whatever I can to generate income from multiple sources.

      4) Grow my revenue and assets no matter what. Make sure I am always expanding and develop them to the point that they consistently generate reliable cash flow.

      5) The most important one – make as much as I can. Save as much as I can.

      iPhones… ecigarettes… Starbucks… Chipotle Burritos…new clothes.. organic lipgloss… expensive yoga classes. Why not try living in your means for once? No wonder we have a debt crisis

  • yololollo

    how is the 11,322.74 calculated via simple interest?

    • I believe it’s based on a 5% interest rate for a $10,000 loan paid over 5 years. Since the balance gets paid down every year, the amount of interest paid each year also goes down. The first year it would be around $500, but in total it would be around $1,322, for a total of $11,322.

      • John Smith

        the total amount (using simple interest) accrued on a 5% interest rate for a $10,000 loan paid over 5 years would be $12,500. For simple interest you use the formula A=P(1+rt)
        A=10,000(1+.05(5))
        A=10,000(1+.25)
        A=10,000(1.25)
        A=12,500

        The answer of $11,322 was found by amoritization not simple interest. Correct me if I am wrong. Thanks

        • Hi John, you may be right but in looking at the formula you used above, the one part I’m not sure of is how monthly payments affect the interest paid over time. For example, if you pay down a certain portion of the balance each month, then you’re not paying interest on the full balance for five straight years, right?

          • John

            Thats exactly the difference between Future Value of Simple Interest compared to Amortization (Both can be used when doing a car loan). Future Value of Simple Interest pays down a portion of the balance and every month the interest is calculated using the amount of the loan as principle(interest would be the same each month). Amortization is calculated every month by using the remaining balance of the loan after each payment is made(interest would change every month)

          • Okay, that’s interesting. I will do a little more research on Future Value of Simple Interest and will update the post with any new information I find. Thanks again for your comment!

          • Brenda Debusk

            Is there a strategic time/way to make car payments, in order to reduce the principal, when based on daily accrual interest?
            In addition, If you pay one payment ahead on the above loan, and pay one month ahead every month thereafter, does this help reduce your interest contribution each month?
            When does a daily accrual interest clock start for a monthly payment?
            On the payment date,
            day after payment date,
            30 days from payment,
            30 days from due date, etc.
            I would really like to understand this.

          • Hi Brenda, I think paying one month ahead would help if your loan is accruing daily interest. But to be sure, you’d need to contact your lender directly and make them answer these questions to your satisfaction. There is some variance depending on the lender and the contract.

  • ADRIANA

    Hi, how can I know how much interest should I be paying monthly for my car loan? Bank says it is a compund interest; which it was never explained to me, until they screwed me up on 2 payments. The annual interest rate is 3.99%, The remaining of the loan is 15596(53 months to pay off), and it was financed for 60 months.

    • Hi Adriana, the amount of interest should be listed on your statement. Based on the numbers you provided above, I think you would be paying about $50 per month in interest.

  • Dusty Rose

    Driving a new car off the lot and facing a huge value drop may not be a concern if you’re not planning to sell the car. However, it can make a huge difference if the car is involved in an accident and totaled. You’ll owe more on the car than you’ll get from your insurance company, won’t you?

    • ButterBeans

      That is what Gap insurance is for!

      • jb1907

        Which is why putting money down will help not having the gap.

  • Grace Lang

    I am paying 2.15 a day with Alaska credit union no matter what the balance of loan is. I called a representative and she said the interest will always be the same. I never heard of this before.

  • Dv23

    I don’t understand why the article doesn’t mention that amortization has compounding. It has an n value that is m*t . m being number of compounds in a given period. So car loans do have compounding if they use amortization.

  • Joshua Conger

    I got a huge question. I financed my car and in order to avoid the daily interest rate I am now 3payments ahead in which all went to the principal amount. They say u no matter how many payments I made no matter if I am 3mths ahead on payments, the daily interest will still occur until I make another payment. Long story short, will daily interest occur no matter how many mths I get ahead.

    • Jay

      If it all went to principal, you shouldn’t be 3 months ahead. You wanted to make a “principal only” payment. Your next payment will then continue to be due at the normally scheduled time. The Teller won’t understand it all. You need to talk to one of the loan officers or bookkeepers.