How does interest work on a car loan?

For a buyer, paying a car loan means repaying the purchase price of the vehicle with interest. Most car loans use simple interest, however there are many factors that determine if you are (i) eligible to receive a loan; and (ii) what rate of interest you will be charged. The latter of the two is what most car buyers look at when shopping for a new or used car; a high interest rate will force you to compromise on your choice of car, while a low interest rate will mean lower monthly payments and a better vehicle. 

There are numerous factors that affect the interest rate on a car loan. Take a look at your credit score, the loan term, and the size of your down payment that can affect the rate of interest on your car loan. 

The Credit Score

Having a high credit score will make it easier for applicants to qualify for lower rates on a car loan. Understanding how credit scores work is immensely helpful before deciding to take out a loan, which can affect the rating. 

According to the Experian’s State of the Automotive Finance Market report for the first quarter of 2020, people who had the lowest scores were nearly lower by 11 percentage points than people with the highest credit scores. These statistics included the average interest rates on new-car loans. It doesn’t sound like a lot but even small differences in credit score can change your rate of interest bracket, which is why it’s best to discuss your score with a credit specialist before opting for a loan. We’ll get into analyzing why people may choose to take out an auto loan for a longer term with lower interest rates later.

How is interest calculated on a car loan?

Auto loans are calculated by lenders in one or two ways: it’s either through simple interest costs or the loan is ‘pre-computed’. Luckily, there is no compound interest, in which case loans would have been charged an increasing rate of interest which would dramatically increase the total amount you would have to pay back. It’s especially important to learn how car loan interest is calculated, to stay within your budget and follow steps to reduce any interest charges. 

Simple interest charges, which are included in your monthly loan payment plan, are assessed on the basis of the price of the car. Simple interest means payment back to the lender is straight forward, but a flat percentage is added on the amount borrowed out. Most auto loans are set to be on simple interest, which means interest payments are front-loaded and amortized. With an amortized loan, car payments have more interest in the beginning of the loan term, than at the end. 

On the other hand, pre-computed interests are calculated upfront based on how much a person is borrowing. In this case, the amount is added to the principal balance, and divided by the number of months in the loan term to determine the monthly payment. These payments are not made separately like with the simple interest loan. More so, if you decide to make extra payments, rather than the minimum due to pay off the loan balance early, you wouldn’t save as much on interest as you would with a simple interest loan. 

Understanding the Numbers: Interest Rate vs. Annual Percentage Rate (APR)

The interest rate is how much interest you pay each year to borrow money, displayed as a percentage. Annual Percentage Rate, also known as APR, reflects the interest rate as well as any additional loan fees. This number is also expressed as a percentage. The higher an APR or interest rate means the more interest you will have to pay out of pocket until the loan is paid off completely. By understanding interest rates and loan terms and how they correlate is important, if you are considering refinancing a car. By choosing to refinance your car, oftentimes it both extends term lengths and secures lower interest rates. 

As a general rule, the longer your payment length the more your cumulative interest charge will be. It may be tempting to take out a longer term loan to reduce monthly payments; however, in the long run you could end up paying more interest, than over a shorter term. 

Here’s an example, a 4% loan for a 5-year period would cost $557.78 a month. At the end of that time, you would have paid $33,466.80 in monthly payments. Add in the $3,365.20 down payment and the real cost of the car will be $36,832. Whereas if you had chosen a longer path, with the 4% loan and opted 8 years for repayment, the monthly payment would be lowered to $369.18. At the end, your loan payments would total $35,441.28. Including the $3,365.20 down payment, the real cost of the car rises to $38,806.48. In the long run, you’ll be paying a higher price for the car, if you consider the longer path. On a budget, that may seem like the more attractive option, however not the best bang for your buck.

How Can I Reduce My Interest Charges on My Auto Loan?

The concept of car loan payment length affects your overall interest charges; it’s a crucial aspect of how you can save money on your current car loan. There are a few ways to minimize the interest charges on your loan. 

0% APR financing: Holding a strong credit, leads to an advantage. The auto manufacturer’s finance division offers this special rate for only a certain amount of time.

Early repayment: With a simple interest loan you can lower your interest by paying more than the minimum or paying the balance off early. 

Shorter loan term: A repayment term, which will lead to the increase in monthly payments but lower the total amount of interest you pay in the long run. 

Refinancing down the road: If the interest rates drop or your credit improves after getting your car loan, you may be able to get a lower rate by refinancing. 

There are several options to consider when learning about interest rates for buying a car, such as whether you should take out a loan on a new car versus a used car. The rates on brand new-car loans noticeably tend to be lower than rates on used-car loans. According to Experian’s State of the Automotive Finance Market report, in the first quarter of 2020,The average interest rate on a used car loan was 9.65% compared to 5.61% on a new-car loan. 

Next Steps

The bottom line is interest rates do play a large factor in obtaining a loan. This may seem tricky at first with the number of changing rates. But, there are plenty of resources available on the web to ease your tension, check out our online loan calculator (no credit check/information required) which will help you plan ahead of time how rates will affect your monthly payment. That way you can go in with a clear picture, and get the best deal available for you. 

Whether you are looking to buy your first car or upgrade to an SUV, 411 Drives is here for you. We work with major Canadian lenders to find the best rates for you.  Speak to an agent or apply now (no-obligation) to discover your options.