When you take out a loan to pay for a car, whether it’s new or used, your monthly loan payment depends on several factors. The price of the car is just one part of the payment. The length of the term and the interest rate both affect the amount. The interest rate is a key part of the calculation and has a significant effect on your payment. Here, we will focus on interest and how to calculate car loan interest.
What Is an Interest Rate?
An interest rate is an amount a lender charges you for borrowing money. It’s shown as a percentage of the principal or the amount loaned. The interest rate can affect the amount you end up paying for a vehicle significantly. It can add thousands of dollars to your repayment amount.
Lenders base the interest rate they charge on a few factors. Your credit history is one of them, along with the price of the car and the amount of your down payment.
How Is Interest Calculated?
Lenders typically calculate interest in one of two ways:
Simple Interest
With a simple interest loan, the lender calculates the interest based on your loan amount on the day your car payment comes due. This means that the amount of interest you pay each month will change. This is the most common way to calculate interest. Borrowers can benefit from paying more than the minimum due because the loan balance and interest amount will decrease.
A simple interest loan has front-loaded interest, and the loan is amortized. This means part of the monthly payment goes to the principal, and part of it goes toward interest charges. Because the loan is front-loaded, a larger part of the payment goes toward interest at the beginning of the loan term, but toward the end, more will go toward the balance left on the principal.
Pre-computed Interest
With a pre-computed interest loan, the lender calculates the interest at the start of the loan. It’s based on the total loan amount, and the amount of interest you pay each month stays the same. The difference between a precomputed interest loan and simple interest is the payments are not separated into interest and principal. If you pay more than the minimum or make extra payments, you won’t save as much.
Common Car Loan Terms Explained
You’ll need to understand several terms if you want to learn how to calculate car loan interest. Some factors that go into calculating a car loan and the interest include:
- Principal amount: This is the amount you need to borrow to buy the car. You can reduce this amount by making a larger down payment, often using the proceeds from the sale of a car or a trade-in. Recalculate the vehicle cost by subtracting the amount of the down payment from the car’s price.
- Loan term: The length of time you have to pay off the loan. In most cases, the longer the term, the lower the monthly payment, but it also increases the total amount of interest you’ll pay over the life of the loan. A shorter term means higher monthly payments, but you’ll pay less interest over the loan period.
- Repayment amount: The repayment amount is how much you pay each month. Part of it goes toward the principal, and part goes toward the interest charges.
- Repayment schedule: You and the lender will set up a repayment schedule. It’s usually a monthly payment, but if you want to pay off the loan faster, you can make additional payments.
Calculating Car Loan Interest for the First Payment
The calculation for your first loan payment is different than the rest of the payments. To calculate it, you need to:
- Divide the interest rate by the number of monthly payments you’ll make each year.
- Multiply the monthly payment amount by the total balance of your loan. For the first payment, this will be the entire principal. This number will be the amount you’ll pay in interest each month.
- Subtract the monthly interest from the fixed monthly payment you’ll make each month to determine the amount of your payment that will go toward the principal.
How to Calculate Car Loan Interest After the First Payment
After you start making payments each month, you’ll pay less toward interest. You can calculate the amount of interest you’ll pay over time by:
- Subtracting the interest you calculated in the previous step from the payment you just made. This will give you the amount of the principal you’ve paid.
- Deducting the total you’ve paid from the original principal to determine your new loan balance.
What Affects the Interest Rate on a Car Loan?
When you apply for a car loan through a lender, they will determine the interest rate they will charge based on a few factors, including:
- Your credit score: In general, people with higher credit scores pay lower interest. This is because they are lower risk. If you have a low credit score, the interest rate will be higher, reflecting the higher risk that you’ll miss payments.
- The type of lender: Banks tend to have higher rates than online lenders and credit unions.
- Loan term: Longer-term loans often have higher interest rates than shorter-term loans.
- Down payment: A lender might lower your interest rate if you apply a larger down payment toward the car. Loans without down payments often have higher interest rates because the lender takes on more risk.
- New car vs. used car: Interest rates on new cars are usually lower than rates on used cars.
- Economy: Interest rates change depending on the market and the economy. Rates rise when the economy is strong to help slow inflation and tend to go down when the economy struggles. Lower rates encourage people to borrow money.
Learning how to calculate car loan interest is a fairly complicated process. To make it easier, you can use an online calculator to work the numbers when you look for a new vehicle.
At FIXD, our mission is to make car ownership as simple, easy, and affordable as possible. Our research team utilizes the latest automotive data and insights to create tools and resources that help drivers get peace of mind and save money over the life of their car.
