How Does Interest Work on a Car Loan?

How Does Interest Work on a Car Loan?
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If you’re in the market for a car, you have to find the money somewhere. The average price for a new car in the United States was ​$36,718​ in ​2018​, although you can cut that cost by buying used. Another option is to take out a loan for a longer term that you pay back over multiple years, but in doing that, you’ll pay interest to the lender.

What Is a Car Loan?

When you can’t purchase a car with cash, lenders give you the option to take out a loan. You’ll repay the loan through monthly payments with interest and fees added on. The interest and fees vary from one lender to the next, but it's all outlined in the documents you sign for the loan.

A car loan is issued specifically to help you buy a car when you don’t have the cash. You borrow the amount you need to purchase the car, then pay back the lender over time. This lets you drive a car while you’re repaying the loan in installments through monthly loan payments.

Why Have a Car Loan?

Ideally, you could pay cash for the cars you buy. But that isn’t always possible. An auto loan gives you the chance to get the transportation you need when you don’t have thousands of dollars lying around.

An alternative to paying cash is to shop around and get the best possible terms on your car loan. You likely won’t get the best interest rate and fees if you go through the dealership. Shop around and look at local banks and credit unions as well as online lenders to make sure you’re getting the best deal possible.

What Is Interest?

A lender takes a risk by loaning money. In fact, in ​2020​, more than ​3 percent​ of auto loan accounts were past due. In exchange for taking that risk, lenders charge interest on the money they loan, allowing them to make money on the deal.

The amount of interest for any type of loan, whether it’s for a car, home mortgage or college, varies based on a variety of factors. As with any loan, a lender looks at your credit history to determine how much of a risk you are, and your interest rate reflects that.

Principal vs. Interest

When you take out a car loan, you’re committing to pay the amount back with interest. Each monthly payment includes both a portion of the money you borrowed and interest. Your loan payment is divided over the length of the loan – typically ​48, 60 or 72 months​.

Borrowers will see the loan amount listed as principal. That’s the amount you’re repaying without taking any interest into consideration. The balance of principal to interest in each monthly car loan payment depends on the type of loan you’ve taken, the amount of money you’ve borrowed and the interest rate you were issued.

Taxes and Interest Charges

As with any purchase, you pay sales tax when you buy a car. The good news is, this sales tax can be added on to the loan amount, so you won’t need to pay the full amount up front. The sales tax is stretched out over the life of the loan, with a small amount included in each monthly payment.

In addition to sales tax, some states also add a personal property tax to vehicle purchases. This can also be stretched out over the life of the loan and incorporated into your monthly payments. The tax rate is based on the value of your vehicle before interest has been added.

How Are Interest Rates Decided?

Whether you’re taking a loan for a new car or a home renovation, financial institutions set their base interest rates the same. It all starts with something called the prime rate, which is set by the U.S. Federal Reserve. The interest rate banks charge is usually ​three percentage points​ above the prime rate set by the Federal Reserve. If the rate is ​1 percent​, you’ll probably see interest rates around ​4 or 5 percent​.

But the lowest interest rate a lender offers isn’t given to everyone. This is known as the prime rate, and lenders reserve it for the best customers. This isn’t an act of favoritism. The quoted interest rate when you request a car loan is based on the following factors:

  • Competition:​ Although lenders don’t directly set rates based on competition, they do keep an eye on what’s going on. They try to keep their rates in line with what borrowers would be offered across the street.
  • Debt-to-income ratio:​ Your credit score speaks to your borrowing history. But your debt-to-income ratio tells lenders where you stand today. The lender looks at how much you owe on various debts compared to how much money you have coming in each month.
  • Length of loan:​ Loan term plays a significant role in the interest rate you’re offered. Longer loans usually have a higher interest rate due to the extended time the lender is at risk.
  • Value of car:​ A lender looks at the car you’re buying when setting your interest rate. If you’re buying a new car that’s worth ​$40,000​, for instance, the lender will likely give you a lower rate than if you’re taking a loan for a ​$10,000​ used car. If you stop paying on your loan and the lender has to repossess it, they’ll be able to recoup more of their investment at resale with a new, higher-value car.
  • Amount of loan:​ The higher the amount you’re borrowing, the bigger the risk to the lender. If you have a trade-in or you can put a little money down, you can reduce the amount you’re borrowing and potentially get a lower interest rate. This also reduces the amount of your monthly payment.

Car Dealerships and Interest Rates

If you buy your car through a dealership, they’ll be all too happy to arrange financing for you. It’s important to note that you’re still borrowing from a lender this way. Dealers work with banks on a customer’s behalf, taking a commission for the service. The dealer commission on financing is typically ​1 to 3 percent​.

The problem with going through a dealership for a car loan is that you won’t know what this finance charge actually is. The dealer negotiates the loan rate with the bank, then couples it with the extra finance charge and presents it as your interest rate. The best thing you can do is shop around and know the best interest rate you can get elsewhere versus what the dealership is offering.

Simple vs. Precomputed Interest

Lenders use a formula to calculate the interest you pay over the course of your loan. With car loan interest, this is computed in one of two ways: simple interest or precomputed interest.

  • Simple interest:​ Most car loans use this method of computing interest. Your interest charges are a percentage of the loan payment that’s due each month. So if your principal in June is ​$400​, interest will be calculated on that amount.
  • Precomputed interest​: Although rarer, this type of interest applies to some car loans. In this scenario, the lender calculates the interest on the entire amount of money you’re borrowing, then divides the amount by the number of months you’ll be paying.

APR vs. Interest Rate

The interest on an auto loan can also be described differently. You may see, for instance, that the interest rate is ​5 percent​ APR. But some lenders express the interest rate without the use of APR.

Here’s the difference between the two.

  • Interest rate:​ This simply refers to the interest you’ll pay on the money you’re borrowing, listed as a percentage of the amount borrowed.
  • APR:​ If you see the letters “APR” after the interest percentage, this is the annual percentage rate. This includes both the interest percentage and loan fees charged by the lender. If you’re comparing two offers, you’ll usually find APR is higher than a simple interest rate.

Read More:The Average APR on Car Loans

Reducing Your Interest Costs

Even a small reduction in your interest rate can save you hundreds of dollars over the course of your loan.

There are some things you can do to get a good interest rate:

  • Improve your credit score:​ By approaching lenders with a strong credit score, you show yourself as a lower risk, which inevitably puts you in line for a better interest rate. Pull your credit report and dispute any errors. This one move can give your score a boost.
  • Shop around:​ There are numerous options for car loans, from large corporate banks to community credit unions to online lenders. Get multiple quotes before you settle on one.
  • Make a down payment:​ Your down payment reduces the amount of money you’re borrowing. Not only could this qualify you for a lower rate due to being less of a risk, but you’ll also be paying interest on a smaller amount.

Refinancing Your Car Loan

A car loan isn’t a lifetime commitment. In fact, if you plan to stay in your vehicle a while longer, it may be worthwhile to shop around for a new loan. Refinancing a car loan is a good idea if your credit score has improved significantly or you’ve found a lender offering a significantly lower interest rate.

Before you shop around for a loan, gather information like your loan amount and interest rate. Then look for lenders offering competitive rates and get preapproved. Many lenders will give you a quote after conducting a soft pull on your credit, so it won’t affect your credit score.

Paying Off Car Loans Early

If you only pay the car payment amount each month, you’ll pay interest and principal for the entire length of the original loan term. However, that isn’t the only option. If you refinance the car, you can reduce the payment or change the term. But you can also pay the loan off early.

Paying off the full loan early can be a great idea if your financial situation changes. Check your loan agreement to make sure there’s no early payoff penalty. You can also pay a little extra on the principal here and there and reduce your total interest payment.

A car loan lets you purchase a new vehicle when you don’t have the cash to buy one outright. It’s important to shop around for the most competitive interest rate to make sure you’re not paying more than absolutely necessary.