Taking out a car loan to buy a new vehicle might seem like a daunting prospect, but it's a very common thing for many car shoppers. Understanding exactly how car loan payments work will make the process seem less overwhelming. As with any loan you take out, you have to pay the lender for giving you the money up front, and they also have to make a profit off your loan, and this is called interest. Car loan interest varies from other types of interest with mortgages, credit cards, student loans and the like, in that car loans tend to charge simple interest rather than compound.
Simple vs. Compound Interest
With compound, interest accrues on your principal (amount owed on the loan) and on the interest that accumulates. The interest can be compounded on any given frequency schedule, from bi-weekly to quarterly. Basically, with compound, you're paying interest on the loan and interest on interest. With simple interest, you only pay interest on your principal, so the overall cost of the loan is cheaper. For example, say you get a car loan for $10,000 with a 5 percent interest rate, and you plan to pay it off over the course of 5 years (60 months). With simple interest, you pay $189 a month, for total payment over those 5 years equaling $11,323. With compounded interest, that same $10,000 loan with a 5 percent interest rate, compounded annually, would equal $12,763 overall.
Car loans also use the principle of amortization, which dictates how much of your payment goes towards paying off the loan and paying off interest. It's a common misconception that your payment goes equally towards both. With amortization, your beginning loan payments have a greater amount going toward paying the interest, than paying off the principal. As the loan progresses, the balance shifts, and more of your payment goes toward the principal than interest. As you pay off your loan, the amount of principal that your interest rate is being calculated on is decreasing, so the amount of interest you owe decreases. But, your monthly payment always remains the same, a greater portion of it is just designated to paying off the principal.
What is APR?
When hearing advertisements for car loans you've likely heard the letters A-P-R thrown around. This stands for Annual Percentage Rate and is different from your interest rate. While the interest rate is just the percentage you owe each month on your principal, the APR should represent the true cost of the loan over your entire payment period, including fees and interest accrued. When shopping around for a car loan, you'll get two quotes, both the interest rate and APR rate. The APR rate is more useful when trying to compare loans from different lenders because it reflects the total cost of financing.
- The length of your car loan will affect how you pay overall, regardless of your interest rate. The general rule is that the longer your term length, the more your cumulative interest charge will be, unless you have an exceptionally lower rate with the longer term.
- One way to save some money on your car loan is by making extra principal payments at the beginning of the loan. You'll already have your regular monthly payments, but if you can manage a few extra payments in the beginning, you can designate these towards paying off the principal. By reducing your principal, you'll reduce the amount of interest that can be calculated. This will allow you to pay your loan off faster and save some money.
- The bigger down payment you can make for the better. Number one, it means you'll have to borrow less, and number two, it means you'll have a smaller amount to pay interest on. Lenders are also likely to see this as a sign of good faith, once you have more invested, and might give you a lower interest rate, because it reduces the amount of risk they take on.
- Deciding to buy new instead of used can mean you get a lower interest rate as there are more incentives and discounts available with a new vehicle purchase.