If you financed the purchase of your vehicle, chances are you’re currently paying interest to the lender. And maybe you’re curious to know how interest is calculated on your auto loan. In this guide, you’ll discover how lenders compute interest, what factors they use to decide on your interest rate and how to determine if you should refinance your current loan to possibly get a better rate.
How Car Loans Are Structured
Car loans are generally for the purchase price of the vehicle plus tax, tag and title fees minus the down payment amount. They’re repayable in equal monthly installments that include the principal balance and applicable interest.
How Interest Is Calculated On A Car Loan
Lenders use simple or precomputed interest to calculate the interest on a car loan.
Simple Interest
These loan products assess interest based on your principal balance on your payment due date. Interest is amortized, and you’ll pay more in interest at the beginning of the loan term. But if you decide to pay more than what’s due each month, the principal balance will decrease faster.
To illustrate, suppose you take out a 60-month $38,000 auto loan with an interest rate of 6%. You’ll get a monthly payment of $734.65 and pay $6,078.79 in interest over the loan term. When you make the first month’s payment, $190 will cover interest, and the remaining $544.65 will be allocated to the principal. But by the time you reach your final payment, only $3.65 will go to interest. The remaining amount will go towards the principal balance to pay the loan in full. `
Precomputed Interest
Unlike simple interest loans, these loan products compute the interest you’ll pay at the beginning of the loan term. Consequently, the total amount the lender charges you in interest is divided by the loan term and tacked on to the monthly principal payments.
Interest Rate Vs. APR
The interest rate is the annual cost of borrowing money. However, the APR (annual percentage rate) includes the amount you pay in interest and the accompanying fees. You can find the APR on your auto loan in the loan disclosure documents.
Factors Affecting Auto Loan Interest Rates
Lenders consider several factors when determining auto loan interest rates.
Credit History
A strong credit score indicates to lenders that you can responsibly manage your debts. So, you’ll likely qualify for the best interest rates if you have good or excellent credit. But if your credit history is a bit shaky, you may get approved for a lower interest rate as the likelihood of you defaulting on the auto loan is higher, and you pose more risk to the lender.
Down Payment
If you have little to no funds available for a down payment, the lender could also charge you a higher interest rate. This results from the lender taking on more financial risk, particularly if you default on the loan towards the beginning of the loan term, the lender repossesses the vehicle, and you’re upside down in the loan.
Loan Term
You may qualify for a loan term of up to 84 percent. But if you’d prefer a lower interest rate, opt for a shorter repayment period. While your monthly payment could be higher, the lender will have less time to collect interest from you.
New Vs. Used Car
New cars typically come with more favorable interest rates. If you cannot afford a new ride, shop around to get the best deal on a used car loan.
Type Of Lender
Auto loans are offered through most banks, credit unions and online lenders. Credit unions tend to charge less than banks, and some online lenders also feature competitive rates.
How Car Refinancing Works
Car refinancing may be a good move if you want to get a loan with a lower interest rate or reduce your monthly payment. The process of refinancing your auto loan involves applying for a new loan to replace your current one and picking up where you left off (regarding the monthly payment) with the new lender.
The idea is to either save in interest by getting a lower rate and paying the loan off early or free up cash by resetting the loan term and lowering your monthly payment. You also need to take into consideration how often you can refinance your car loan if you have done so in the past.
FAQs About Interest on Car Loans
Below are some common questions related to interest on car loans:
If the lender doesn’t charge a prepayment penalty, it’s sensible to pay off your car loan faster. You’ll free up cash that can be used to meet other important financial goals sooner than later.
You can lower the interest rate on your car loan by refinancing. Be sure that your credit score is up to par before applying for a new loan to increase your chances of getting approved for a loan product with competitive terms.
It varies by lender. Read the loan agreement carefully to determine how your lender calculates interest.
Some lenders charge prepayment penalties if you pay your car loan off early. Read the financing agreement or contact your lender directly to inquire.
