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How Does Interest Work on a Car Loan?

How Does Interest Work on a Car Loan?
Austin Kilham

Austin Kilham

Updated September 30, 2021
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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 loanRecommended: Learn more about Auto Loan Terminology

How Is Car Loan Interest Calculated?

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 = interestLet’s say you take out a five-year auto loan of $20,000 at an interest rate of seven 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.(.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.

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?

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 four % interest for a term of 48 months. Your very first monthly payment would include $93 for interest payments and $539 to principal payments. By month 47—after you’ve paid off most of your principal—$2 of your monthly payment will go toward interest, while $632 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.   Over the life of the loan, though you may be able to pay the loan down earlier.   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. 

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 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 influence the interest rate lenders offer on an auto loan. Here’s a look at some of the most common.

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 4.09% during the second quarter of 2021, it was 8.66% for used cars. 

Credit Score

Lenders 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 second quarter of 2021, borrowers with the highest credit scores were offered interest rates of 2.34% on average for a new vehicle, while borrowers with the lowest rates were offered average interest rates of 14.59%.  

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 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

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. 

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 the numbers:

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 available to you. 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

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.
Photo credit: iStock/busracavus
The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.SOLC0821142

About the Author

Austin Kilham

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.
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