How Does Interest Work on a Car Loan?
If you’re in the market for a new car, you might be thinking about getting an auto loan. Financing a car allows you to pay it off over a certain number of months, rather than paying the entire cost upfront. In exchange for lending you the money, you must pay the lender back what you borrowed, plus interest.
In this article, we’ll explain how car loan interest works and how it’s calculated. We’ll also share how you can get the lowest interest rate for your situation.
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How Do Car Loans Work?
Before we get into car loan interest, it’s helpful to understand how car loans work.
A car loan is a legal contract between you and a lender, like a bank or credit union. Most auto loans are secured, using your vehicle as collateral. That means if you default on your payments, the lender has the legal authority to repossess the vehicle.
Under the terms of the loan contract, the lender agrees to loan you an amount of money, which you must pay back over a fixed period. You must also pay interest on the money you borrowed.
Every month, you make a payment that goes toward your loan principal and covers the interest. Once the loan is fully paid off, you become the legal owner of the vehicle. At that point, you have the ability to sell the car whenever you want.
What Is a Car Loan Interest Rate?
A car loan interest rate is the cost of borrowing money from a lender. You’ll see this fee expressed as a percentage.
Loan interest rates depend on a few criteria, including your credit score and the kind of car you want to buy. In general, you can qualify for better interest rates if you have excellent credit.
How Does Interest Work on Your Auto Loan?
Auto loan interest rates can be confusing, so let’s look at a real-life example to demonstrate how it works.
Let’s say you buy a car that costs $32,000. You put down 10 percent of its value, which is $3,200. This means you’re financing the rest, which is $28,800.
Now, you owe $28,800 and want to take out a 60-month loan. The lender gives you an interest rate of 4.21 percent because you have good credit. Over the course of five years, you’ll pay $3,187.77 in interest. Your monthly payment would be $533.13. By the end of your loan term, you’ll pay $31,987.77.
Now, let’s look at the same loan with a lower credit score. If you have subprime credit, your lender might give you an interest rate of 11.33 percent. This means your monthly payment would be $630.93 over the course of 60 months. Over five years, you’d pay $9,055.92 in interest alone. By the end of your loan term, you’ll pay $37,855.92.
As you can see, even if you apply the same down payment, your interest rate changes how much you spend over the course of your loan term. This is why it’s important to get the lowest interest rate possible.
How Is APR Different from an Interest Rate?
It’s a common misconception that APR, or the annual percentage rate, is the same thing as the loan interest rate. However, that’s not the case.
The APR of your loan is equal to the interest rate plus other loan fees you must pay, like financing charges. Your lender will tell you the APR when you receive a loan offer. The higher your APR is, the more you’ll pay to borrow the funds for your car. Keep in mind that your APR will likely be higher than your interest rate.
How Do Lenders Calculate Your Interest?
Lenders use one of several methods to calculate your interest rate on an auto loan. The method the lender uses will impact the cost of borrowing money. These are the two msot common methods of calculating your interest rate:
Simple Interest Loan
Most auto loans are simple interest loans. If you have a simple interest auto loan, the lender calculates your interest rate based on the loan balance on the day of your car payment. This means you will pay a different amount in interest each month.
A simple interest loan has major benefits. For instance, you can pay less in interest if you pay more than the minimum payment each month. In most cases, you will pay more interest at the beginning of your loan term than at the end. By the end of your loan, more of your monthly payment goes toward the principal.
A simple interest loan does have one downside, though. When an auto loan is front-loaded with interest like this, it means the loan is amortized. So, when you first start making your payments, you owe more than your car is worth, which means you have negative equity.
Precomputed Interest Loan
If you have a precomputed interest loan, the lender determines your interest at the start of your loan. This figure is based on the total amount of your loan, so you’ll pay the same amount of interest each month.
The total interest you’ll pay is divided evenly over the course of your payment term. When you pay more than the minimum amount due, you’ll still pay interest on the full principal. In short, you won’t save as much money with this kind of loan.
What Is the Average Interest Rate for Auto Loans?
As of 2022, the Federal Reserve says the average auto loan rate from a commercial bank is 4.85 percent for a 60-month new car loan. For a 72-month new car loan, the average interest rate is 5.19 percent. However, your interest rate might be higher or lower based on a variety of factors that are personal to you.
What Is a Good Interest Rate?
There’s really no such thing as a “good interest rate.” Ultimately, a good interest rate is the lowest rate you can get for your situation. To find the best interest rate, it’s important to shop around and compare rates from a few lenders.
What Factors Impact Your Interest Rate?
When you apply for an auto loan, the lender will look at a variety of factors to determine your interest rate. Here are some of the factors that your lender will consider:
Credit Score
Your credit score has a significant impact on your interest rate. If you have a good credit score, your interest is going to be lower compared to someone with a poor credit score.
Borrowers with very low credit could see interest rates as high as 14 percent, whereas borrowers with excellent credit could see interest rates as low as 3 percent.
General Auto Loan Interest Rates
Interest rates for auto loans can change on a daily basis. Keeping tabs on the current rates can help you determine the best time to buy a car. Additionally, auto loan interest rates can vary based on the type of lender you use, such as a commercial bank or an online lender.
Down Payment
Lenders might charge you a lower interest rate if you make a big down payment on your new vehicle. If you put very little money down, the lender might determine you’re at a higher risk of defaulting on the loan. Additionally, making a larger down payment means you can borrow less money to finance the car.
Principal Amount
The principal of your loan is the amount of money you need to borrow. This is the money you’re using to purchase the vehicle. Your principal makes up the highest figure in your loan amount, so it has a significant impact on your car loan interest rate.
Loan Term
The loan term is the length of time it will take for you to pay off the loan. If you take out a short-term car loan, you’ll have higher monthly payments. You’ll also pay less interest over the span of your loan.
On the other hand, a long-term car loan comes with lower monthly payments. However, you’ll pay more interest.
Type of Vehicle
The type of vehicle you want to finance will also impact your auto loan interest rate. Generally, the interest rate for new cars is less than the interest rate for used cars. Used cars have already depreciated, and the lender might also see them as higher risk than new cars.
Work and Education History
You might not think your resume has much to do with your auto loan, but it could. When the lender determines your interest rate, it might consider your level of education and work history.
Repayment Schedule
The frequency of your payments will also play a role in your interest payments. For example, if you make two payments each month, you’ll pay less in interest than if you make a single payment each month. You can choose a repayment schedule and amount that helps you pay the least amount of interest.
What Can You Do to Get a Better Car Loan?
Every driver wants to find the best auto loan rate for their personal situation. Here are a few ways you can improve your auto loan terms.
Pay Off Your Loan Early
If you can afford to pay off your loan early, you’ll save money on interest, assuming you have a simple interest loan. By making higher payments on your principal each month, you will reduce the amount of interest you pay significantly.
Low APR Special Financing
Some car dealerships offer special financing deals, where you can get a new car with 0 percent APR. However, these deals are usually only available to borrowers with excellent credit. Most dealerships advertise these incentives online. You can also call around to dealerships in your area and ask if there are any deals going on.
Choose a Shorter Loan Term
You’ll spend less money on interest if you pay off your loan over a shorter period. While your monthly payments will be higher, you’ll be paying much more on your principal. If you pay more than the minimum amount due, you can shorten your loan even more.
Get a Co-Signer
If you have a co-signer on an auto loan, you’ll be in a better position to get a good interest rate. You’ll also improve your chances of approval if your co-signer has excellent credit. Even if lenders consider your credit score subprime, having a co-signer can help you avoid a very high monthly payment.
Wait for Interest Rates to Drop
Sometimes, finding a good deal is all about timing. If average car insurance rates are extremely high, you might want to wait until the rates come down before you purchase vehicle.
Refinance Your Vehicle
If you already have an auto loan, but you’re unhappy with your interest rate, you always have the option to refinance for the chance to get a lower rate. This is a great option if you have better credit today than you did when you first got the loan.
Save Up a Higher Down Payment
When you put more money down on a car, you can borrow less. Borrowing less money means you can get a better interest rate and lower monthly payments.
Get Preapproved Before You Shop
Before you start shopping for vehicles, it’s a good idea to get preapproved for a loan. This gives you an idea of what interest rate you can qualify for.
If you find a car you love and want to finance it through the dealership, you may be able to use your preapproval letter to negotiate better loan tems.
Is a Car Loan Worth It?
For many drivers, a car loan is absolutely worth it. Even if you can afford to purchase a vehicle in cash, there are still benefits to taking out a loan instead. However, it’s important to choose the best auto loan for your situation, which takes some research and consideration.
Before you sign any loan, make sure you know the interest rate, monthly payment, and repayment terms. Only choose a loan that you can comfortably afford to pay based on your current financial situation. If you take on a loan that’s too expensive, it could have a negative impact on your credit score, and potentially, your ability to keep the car.
Finance & Insurance Editor
Elizabeth Rivelli is a freelance writer with more than three years of experience covering personal finance and insurance. She has extensive knowledge of various insurance lines, including car insurance and property insurance. Her byline has appeared in dozens of online finance publications, like The Balance, Investopedia, Reviews.com, Forbes, and Bankrate.
