Finance

How Are Car Loan Interest Rates Determined?

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You’ve been approved to finance a vehicle. Congratulations!

Financing a vehicle means that either a bank or the dealership that you’re buying with is letting you use their money, and in exchange, you will pay them back, plus a certain amount of interest over a agreed upon period of time.

Most car loans use simple interest, which is a type of interest where the interest charge is only calculated on the principle (the amount owed on the loan). The benefit here? Simple interest doesn’t compound on interest, which saves you money.

Simple interest doesn’t mean that every time you make a payment on your loan, you pay equal amounts of interest and principle. Instead, your loan is paid down via amortization, which means with each payment the amount of interest you pay decreases. So you end up paying more interest in the beginning and less by the end.

How Much Interest Am I Paying?

Let’s say you find a vehicle you really like. It’s $16,000. Sales tax is 0% (for simplicity’s sake) and you’re able to lock down an annual interest rate of 10%, over five years. Finally, you decide to put $2,000 down.

interestrates

Using the formula above, you can calculate how much interest you’ll be paying over the course of five years. Don’t worry, though, we did the math for you. Using this formula, we determined that your payments would be approx. $297 a month, or $148.50 bi-weekly.

With amortization, the amount you pay in interest will steadily decrease, while the principle amount you’ll be paying off will increase, in order to keep your payments at $297 every month. Take a look…

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As you can see, as you pay off your car loan, the amount of interest you pay decreases while the amount of principle you pay increases, all while the monthly payment remains the same.

In the end, you’ll have paid $14,000 in principle and approx. $3,848 in interest. Want an easier way to figure this all out? Use our Car Loan Calculator.

How Does the Length of My Car Loan Affect How Much Interest I Will Pay?

A General Rule of Thumb – The longer your term length is, the more your total interest charge will be. If you can afford higher monthly payments over a shorter period of time, you’ll end up saving yourself money in interest payments. thumb

How Can I Pay Less Interest?

Make an unscheduled payment! Essentially, the amount of interest you’re paying is determined by how much money you have left owing on your car loan. By putting additional, unscheduled money against the loan, you lower the principle, thus lowering the interest.

Obviously, if you have some expendable income, putting it against your car loan is never a bad idea. However, always make sure that there aren’t other things that need that extra money more. For example, credit cards usually have higher interest rates, so oftentimes it’s more beneficial to pay them off first. At the end of the day, make sure an unscheduled payment is safe and what’s best for you.

Another option? Refinancing! If you can refinance to a lower interest rate, you may be able to pay less for your loan than what you were originally quoted.

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