How Does Interest Work On A Car Loan and How Can You Get The Best Rates?

ByG. Dautovic
June 29, 2021

When you decide to take a loan, you will be bombarded with a lot of “interest talk.” If you are not familiar with how interest works, you could end up paying a lot more than you intended or could afford.

Car loans are no different, and interest rates are an essential part of each car loan negotiation. We’ll answer the question “how does interest work on a car loan?” and tackle all its related issues in this guide. Once you understand it, you will be able to successfully estimate whether any given car deal is good enough for you.

Car Loan Interest Factors

Let’s discuss what influences car loan interest below:

Credit Score

Your credit score is the first thing you can expect any lender to look at, and it influences interest rates heavily. This is because lenders determine the risk they take on by providing you with a loan based on your credit bureau credit score.

Therefore, people with good credit scores will likely get better or, to be more precise, lower car interest rates. Experian’s State of the Automotive Finance Market report revealed that people with the highest credit scores got nearly 11% lower average interest rates than those with the poorest scores. If you’re not in too much of a hurry to buy a new vehicle, work on improving your credit score before going into a lender’s office.

Lender Type

When you decide to take out a loan for a new car, you might be overwhelmed by all the excellent car loan options. You can get a car loan at most banks, credit unions, and some online lenders; each solution has its pros and cons.

If your primary concern is getting the lowest car loan interest rate, credit unions are your best bet, as they typically have lower interest rates than banks.

On the other hand, there are also automaker finance companies that offer auto loans. These also have occasional special promotions, even some 0% APR offers, which can make for a great deal.

Term Length

Loan length is another heavy influence on the interest rates. While going for the most extended available length term is undoubtedly tempting, as it will make your monthly payments lower, this option can backfire and definitely won’t get you the best interest on a vehicle loan.

First of all, car values are known to depreciate quickly. With an extended loan length, you risk your payments adding up to much more than your car’s worth by the time you’re debt-free.

Also, the longer you have to repay, the longer you have to pay the interest, so you’d end up paying much more regardless of the rate. Even though the interest doesn’t accrue with simple interest loans, getting rid of it as soon as possible is the way to go with every loan.

Down Payment

Down payments are also part of every “what determines interest rates on car loans” factor list. If you put little or no money down, you can expect higher interest rates from lenders. Lenders take a risk by dealing with you, and they will want to cover all their bases. If you don’t pay the money back or default on a loan, even though they do typically have the car as collateral, it might not be worth enough to cover the loss of giving you the loan in the first place.

Gather your funds for the highest down payment you can afford before going to a lender. This will get you a much better offer in terms of car loan interest rates.

Interest Rate Environment

Interest rates fluctuate based on the market conditions, so getting a loan when the times are tough or waiting for a better deal is a choice every borrower needs to make.

Rates are typically lower in challenging times for the market, when lenders need people to take out loans. When the economy is stronger, higher interest rates stop inflation.

These rates change daily, especially for auto loans, so check the current rates before you walk into a showroom. If they’re reasonable, you might want to get pre-approved by the lender. 

Used or New Car

Whether your vehicle of choice is used or new can also influence car payment interest rates. Contrary to what you might expect, they’re usually better for new cars than used ones. The truth is, lenders want you to get new cars, because people with higher credit scores tend to go for new vehicles, and repossession risks are much lower for them.

While this isn’t a rule, it does explain why interest rates on used car loans are notably higher. If we return to Experian’s State of the Automotive Finance Market report, we’ll find that the average 2020 automobile loan interest rate on a used car was 8.43%, and 4.31% for a new one. The latter is below the overall auto loan rate average, according to car loan stats.

There are two additional things you should know about car loans:

Good auto loans include simple interest costs.

In other words, the borrower pays the money back, plus an agreed percentage of the amount. The alternative would be a compound interest loan, which would make paying back the loan challenging and even more expensive. Luckily, compound interest car loans are very rare.

Auto loans are amortized.

Loan amortization means calculating regular payments based on both the principal and interest. With car loans, interest is front-loaded in the early payments, with the later ones going primarily towards the principal.

How To Calculate the Interest on a Car Loan

The simplest way is to use one of the many available online interest calculators, as there are many factors in the equation to add to the formula. Still, if you are up for brushing up on your math skills, we’ll guide you through the steps of calculating your possible interest yourself.

Let’s say, for example, you decide to take out a $15,000 loan, paid over 60 months, with no down payment, an interest rate of 10%, and a $318.71 monthly payment. Let’s go step by step to show you how to calculate your car payment and its parts:

  1. You’ll want to multiply the loan’s principal with the interest rate to get the total interest amount ($15,000 x 0.10 = $1,500).
  2. Next, you divide the total by the number of days in a year to get the daily interest charges ($1,500 ÷ 365 = $4.11).
  3. Multiply the daily interest with the number of days in a month - either 30 or 31, but we’ll take 30 - to determine how much of your monthly payment is going toward the principal and interest ($4.11 x 30 = $123.29). It means that out of the $318.71, $123.29 will go towards interest, and $195.42 will pay back the principal.
  4. You should repeat this process the next month, using the same car loan interest formula, but with a reduced principal (in this case, $15,000 - $195.42 = $14,804.58) and adjusting the number of days for the month you’re in.

Ultimately, you’ll notice that the amount of money going toward the principal increases, and the interest payments decrease, while your payment total stays the same. As mentioned before, you can use online tools to get an amortization table and keep track of these numbers.

How To Pay Less Interest

There are several ways to reduce the interest amount you’ll have to pay. While this depends on the type of loan you took out, some universal rules apply for paying lower interest rates for car loans.

Early Repayment

The best way to pay less in interest is to get out of the loan as soon as possible, which means paying it off in the shortest time. You can do this by paying a bit more than the minimum due each month or paying off your entire balance early.

Round Your Monthly Payments Up

Over time, every dollar over the minimum can stack up to noticeable results. If you were to take out the example loan we’ve used above, paying $330 instead of $318.71 every month won’t change the interest rate for a car loan, but it will result in a lower total interest amount.

Ask for a Shorter Loan Term

As mentioned before, if you can afford higher monthly payments, then ask for the shortest loan possible. While this may seem too expensive, in reality, you’ll end up paying less, as you’ll have less interest to pay in the long run.

Refinance if Things Improve

Interest rates change over time, and so does your credit score; it’s vital to keep an eye out for any changes in these two aspects. If either changes in your favor, you should consider refinancing, as you’ll likely be able to get a lower rate.

FAQ
How is interest calculated on a car loan? +

With car loans, the interest is typically fixed and based on the principal. This method makes for easy calculation based on the principal amount, term length, and, further down the line, based on the number of days in a month and the constantly lowering principal.

Do you pay interest every month on a car loan? +

Most car loans work on the simple interest principle, meaning that interest is calculated as part of your monthly payment. This means that you pay the interest every month.

Do auto loans accrue interest daily? +

This is a common question from people wondering: “How does interest work on a car loan?” Auto loans are typically simple interest loans - meaning that the interest is calculated in monthly payments, and therefore, it is paid off each month and doesn’t accrue.

About author

I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.

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