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When you take out a car loan, the interest is the amount you pay your lender for the opportunity to borrow from it. Car payments are amortized over the life of your loan, which means that in addition to the amount you’ll pay each month to pay down your principal, you’ll also owe interest.The interest rate you’ll be offered on your loan will vary depending on a number of factors, including your credit score and the length of your loan, also known as the loan term. Interest payments are a costly part of financing your car, so it’s important to understand how they’re calculated so you can get a clear sense of what a good interest rate is as you shop for an auto loan.Recommended: Learn more about Auto Loan Terminology

How to Calculate Interest on a Car Loan

If you want to figure out how much interest you’ll be paying each month as you make payments on your auto loan, the easiest thing to do is to find an amortization calculator online and plug in the numbers.But it’s not much harder to figure it out yourself. You’ll need the same basic information:

Your interest rate

How often you make payments

Loan principal

Here is the formula to figure out how much of your monthly loan repayment goes to interest:(interest rate / number of payments per year) x loan balance = interest amount owedLet’s say you take out a five-year auto loan of $20,000 at an interest rate of 8 percent. If you’re making monthly payments, we’ll make the number of payments 12. Since we’re looking at your very first payment, the balance is still $20,000. Then we plug in the other numbers:(0.08 / 12 ) x $20,000 = $133.33 = amount of your first payment that will go toward interestAs you pay down the amount of your principal, the amount of each payment that’s going toward your interest will also grow smaller.

Car Loan Interest Formula

A car loan may include daily simple interest charges and a fixed monthly payment. This means a variable portion of your monthly payment may go toward principal and interest. A larger portion of your monthly payment may go toward interest at the beginning of the term, and a smaller portion of your monthly payment may go toward interest near the end of the loan term.As mentioned earlier, you can use this simple interest formula to calculate how much of your monthly payment goes toward interest:(interest rate / number of payments per year) x loan balance = interest amount owedThe interest rate in this formula is expressed as a decimal. For example, a 5% interest rate would be expressed as 0.05.Your outstanding loan balance decreases with each payment, so this formula could be applied each month to determine how much of your payment went toward interest charges in that particular month. This is the formula used by online amortization calculators to estimate total interest costs over the life of your car loan.

Car Loan Interest Example Calculations

Here are some car loan interest example calculations:

48 Months at 3%

A 48-month car loan with a $25,000 loan balance, 3% annual percentage rate of interest, and $553.36 monthly payment would include the following interest charge:(0.03 / 12) x $25,000 = $62.50 interest charge for the month in question

72 Months at 3%

A 72-month car loan with a $530.45 loan balance, 3% APR, and $531.78 monthly payment would include the following interest charge:(0.03 / 12) x $530.45 = $1.33 interest charge for the month in question

48 Months at 6%

A 48-month car loan with a $25,000 loan balance, 6% APR, and $587.13 monthly payment would include the following interest charge:(0.06 / 12) x $25,000 = $125 interest charge for the month in question

72 Months at 6%

A 72-month car loan with a $577.17 loan balance, 6% APR, and $580.05 monthly payment would carry the following interest charge:(0.06 / 12) x $577.17 = $2.89 interest charge for the month in question

Simple vs. Precomputed Interest

Most car loans use a simple interest formula, which is what we discussed in the last section. This means that the amount of interest you owe each month is a percentage based on your principal, or loan balance, as of the day your payment is due.In some cases, especially for subprime borrowers, a car loan might use precomputed interest instead of simple interest. This means lenders calculate the amount of interest upfront and add it to the principal. They then divide that total by the number of months in your loan term to get your monthly payment. Your payments don’t apply to interest and principal separately.And if you make extra payments, you likely won’t be able to lower the amount of interest you pay over the life of the loan as much as you would by prepaying on a loan with simple interest. However, if you’re only going to make the minimum payment each month, it may not make much difference to you.

How Is Interest Paid on a Car Loan?

The way how car loans work is that lenders provide financing to help borrowers purchase a new or used vehicle. Borrowers are expected to repay the car loan over a set term, and these loans may include interest charges stemming from an annual percentage rate or APR.Consumers with good credit may qualify for auto loans with 0% APR. In general, good auto loan interest rates fall under 5%. The average interest rate on new car loans in the first quarter of 2022 stood at 4.07%, according to Experian data.Typically, an auto loan will use simple interest. When you make a payment, a portion of that payment will go to paying the interest you owe that month and the rest will go to paying your principal. In the early months of your loan, you’ll owe more interest, and a greater portion of your monthly payments will go toward paying it off. As your loan balance gets smaller, you’ll owe less interest. Thus interest will become a smaller portion of your monthly payment and more of your money will go toward paying off your principal.For example, say you take out a $28,000 auto loan with 4% interest for a term of 48 months. Your very first monthly payment would include about $93 for interest payments and $539 to principal payments. By month 47 — after you’ve paid off most of your principal — about $2 of your monthly payment will go toward interest, while $630 will go to paying off the remainder of your loan.If you prepay your loan (meaning you make one or more larger payments than the amount due), you can pay down your principal faster, potentially decreasing the amount of interest you owe. Be aware that some lenders charge prepayment penalties, so check your loan agreement before making prepayments.In the less typical case that you’re charged precomputed interest on your loan, things can be a little different. Instead of amortizing the loan, the lender calculates the total amount of interest you would have to pay on the loan over its full term, assuming you didn’t prepay. It totals all that interest and then adds it to the balance. You then make a payment on a fraction of that total each month.The rules for prepayment are different and often favor the lender, so even if you prepay, those payments won’t have the same impact that they would have if your loan were calculated with simple interest.Consumers may ask, “What happens to car loans when someone dies?” The answer is that car loans do not simply disappear when a borrower dies. A surviving spouse may be responsible for paying the debt, or a lender may move to repossess the vehicle.

Is Car Loan Interest Tax Deductible?

Car loan interest is tax deductible in limited cases. Traditional employees generally can’t deduct interest paid on a car loan, but self-employed taxpayers may deduct car loan interest if they use the car for business purposes.A tax deduction can reduce the amount of income tax you may have to pay or increase the size of your tax refund. The car interest deduction is limited to self-employed taxpayers who pay interest on a car loan and use the vehicle for business purposes.The amount of car loan interest a self-employed taxpayer may deduct is determined by how much the taxpayer uses the vehicle for business purposes. Self-employed taxpayers who use their vehicle 60% of the time for business may deduct 60% of their car loan interest when reporting profit or loss from their business.

Car Loan Interest vs. APR

As you shop for auto loans, in addition to interest rate, you may also see annual percentage rate (APR) listed. (And if you don’t see it, it’s worth asking about it.) These two numbers are usually pretty close together, but APR can give you more information about how much you’ll actually owe over the life of your loan.While interest rate is a percentage that shows you how much you will pay to borrow alone, APR is a percentage that shows you your interest rate plus any other fees you might owe. APR illustrates total costs for financing a vehicle. The federal Truth in Lending Act generally requires that all lenders disclose APR, which can make it a good metric to use when comparing the true cost of borrowing as you shop for a loan.

What Determines Interest Rates on Car Loans?

There are a variety of factors that may influence a lender’s auto loan interest rate offers. We highlight some of these factors below:

Type of Lender

Some lenders, particularly captive finance companies, may offer 0% APR on new car loans. The following lenders may offer their best rate to borrowers with excellent credit:

Banks

Credit unions

Buy here, pay here dealerships

Independent finance companies

Captive finance companies affiliated with auto manufacturers

New vs Used Financing

Used vehicles tend to carry higher interest rates than new cars. While the average interest rate for a new car loan was 4.07% during the first quarter of 2022, it was 8.62% for used cars.

Credit Score

Lenders may use your credit score as an indicator of how likely you are to pay down your debt on time. They see borrowers with higher scores as less risky and will typically offer them lower interest rates. In the first quarter of 2022, borrowers with the highest credit scores saw rates of 2.4% on average for new vehicle financing, while borrowers with the poorest credit scores saw interest rates of 14.76% on average.

Loan Term

Lenders see longer loan terms as riskier, so they may charge higher interest rates for them. This can lead to a phenomenon known as an upside down loan. Cars generally depreciate quickly, and a long term and higher interest rates may mean you’ll eventually end up owing more on your loan than your car is worth.

Down Payment

A lender calculating car loan APR may offer you a lower interest rate based upon the size of your down payment. The more money you put down when you buy a car, the lower the interest rate a lender is likely to charge. It follows that the less money you put down, the more it will charge. That’s because your lender wants to balance the risk that you might default and leave them with a depreciated vehicle worth less than the amount you had left on your loan.

Interest Rate Environment

The interest rate environment can influence a lender’s decision-making concerning auto loan financing. When the Federal Reserve raises its fed funds rate target range to combat inflation, lenders may follow suit by raising their interest rates on consumer loans. Interest rates on consumer loans may be more affordable when the Federal Reserve lowers its fed funds target range to stimulate the economy.

Average Car Loan Interest Rates

The average car loan interest rate will vary depending on a person’s credit score and loan term and whether they’re buying a new or used vehicle. Here’s a look at key data highlighted by Experian in its State of the Automotive Finance Market report:

Risk category

Credit score

Average new car loan rate

Average used car loan rate

Average auto refinance interest rate (Oct. 2021)

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Tips for Lowering Interest on Your Car Loan

If you want to pay less interest on your car loan, there are a few options that may help.First, when you’re selecting a loan, you can choose one with a shorter term. Though this will increase the size of your monthly payments, you’ll pay less interest over the life of the loan. Prepaying your loan can also reduce the amount of interest you pay if you have a simple interest loan. As you pay off your principal, the amount of interest you pay will get smaller faster. Just look into whether your loan carries any prepayment penalties. Even if it does, you might be able to save money by paying your loan, or part of your loan, early.You might also consider refinancing your loan, especially if interest rates drop or you improve your finances. When you refinance, you pay off your old loan with a new loan that hopefully offers you a term or interest rate that better fits your needs. Typically, you’ll get the best results when refinancing if you have good credit, but it is still possible to refinance when you have poor credit.Comparing your options and paying attention to the details are among the auto loan refinancing tips you could consider as a consumer.Borrowers are expected to provide proof of identity and proof of income when applying for auto loans or refinancing, among other auto loan requirements.

The Takeaway

Once you understand how interest is calculated, the factors that can affect it, and how it differs from APR, you’re in a better position to compare auto loans and find the one that’s right for you. You’ll also have a better sense of the strings you can pull if you ever want to pay less interest on your loan, whether by prepayment or refinancing.Visit Lantern by SoFi to learn more about your options for refinancing auto loans. Fill out one simple form to see multiple offers from our network of lending partners.

Frequently Asked Questions

Is car loan interest tax deductible?

Does paying a car loan off early mean you pay less interest?

Can you calculate car loan interest manually?

What is the formula to calculate car loan interest?

Photo credit: iStock/busracavus

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About the Author

Austin Kilham

Austin Kilham is a writer and journalist based in Los Angeles. He focuses on personal finance, retirement, business, and health care with an eye toward helping others understand complex topics.