Unlike watching car review videos, spec-ing out different models, and taking test drives, thinking about how you'll finance your new car is neither thrilling nor sexy. We get it - car loan interest is the last thing you want to worry about when you're hyped to buy your new vehicle. However, after the new car smell wears off, you'll still be stuck making your car payments. Putting some thought into the seemingly humdrum process of financing your vehicle can save you thousands of dollars (not so boring anymore) and it's often more simple than it seems. Learn how a simple interest car loan works and how you can use it to your advantage.
What is a Simple Interest Car Loan?
Simple interest loans are the most common type offered by auto lenders. This type of car loan falls into the category of amortizing loans which calculate interest on a preset basis, such as daily. During each period, interest is calculated based on the amount of principal (the amount you borrowed) outstanding on the loan. Even though your monthly payment stays the same each month, an amortized loan means part of that payment goes towards the principal while another part goes towards the interest charges.
A simple interest car loan is front-loaded, meaning that at the beginning of the loan, more of the monthly payment is going towards the interest while at the end of the loan, more is going towards the principal. If you pay more than the minimum due, both the interest you owe and your loan balance will decrease.
According to LendingTree, "if a borrower pays off additional principal on their loan, they will no longer have to pay interest on the additional principal that has been paid off. Early payments allow borrowers to pay off simple interest loans faster while paying less in interest over the life of the loan".
Calculating Simple Interest Car Loans
To help you understand how lenders calculate the payments on a simple interest car loan, Credit Karma offers this example: "Imagine that you take out a $25,000 car loan with a 48-month term and a 4% interest rate, you’ll pay an estimated $83 in interest and $481 in principal during the first month of the loan term. By the last month, you’ll only pay an estimated $2 in interest, and $563 will apply to the principal amount".
Simple Interest vs. Precomputed Interest
Simple interest car loans are far more common, but you may find some lenders offer precomputed interest rate loans. Unlike a simple interest car loan where the portion of the monthly payment going to principal vs. interest is dynamic, precomputed interest car loans tie you into a set payment schedule. Precomputed loans have a predetermined amount going to interest and principal every month. To determine your monthly payment, the lender calculates the interest upfront based on the amount you're borrowing, adds it to the principal, and divides the total by the number of months in your loan term. Although there are pros and cons to each type of auto loan, simple interest maximizes your opportunity to save money.
Pros and Cons of Simple Interest Car Loans
The benefits of a simple interest car loan include more flexible payment options and the potential to save money on interest. Simple interest car loans let the borrower reduce the overall interest on the loan by paying early or paying more, and there are usually no penalties for doing so. With a precomputed car loan interest rate, if the borrower wants to make an early payment or pay more than the minimum, they will not be able to take advantage of the savings.
On the other hand, a simple interest car loan puts a large chunk of your initial payment towards the interest and not the principal which means you have less equity in the vehicle to start. While the percentage of the monthly payment going to the principal increases with time, you may put yourself at higher risk of being upside down on your auto loan at the start of the loan term.
How to Save Money with a Simple Interest Car Loan
Choosing a simple interest car loan is the first step to saving money on interest, but to reap the benefits you'll need to be proactive in paying off the debt. In order to save on the total interest over the loan term, you have several options for making payments. These fall into two categories: the amount you pay and the timing of payments. According to CarsDirect, a few of these options include rounding up payments, paying more when possible, and payment splitting.
Car Payment Amount
Rounding up payments is an easy and painless way to pay off your loan faster and save on interest. Just like retail stores often ask you to round up your total for charity at checkout, you can take the same approach with your auto loan. If your monthly payment is $479.99, you can round up and pay $500. While this doesn't add much more to your payment each month, it will help you pay off the loan sooner and pay less in interest. Another option is to simply pay more than the minimum when your budget allows and return to the original payment when necessary.
Car Payment Timing
Payment splitting allows you to time your car loan payments in a way that reduces the amount of interest that accumulates daily. This strategy involves splitting your car payment into two installments each month. The first installment is paid early and the second is paid around the normal due date. Without increasing how much you pay each month, this tactic can add up to substantial interest savings over time.