How Does Interest on a Car Loan Work?

Your car loan has a significant impact on how much you end up spending to buy a new automobile. An understanding of how car loans, including promotional rates from manufacturers, are calculated helps you find a car that suits your budget. It can also help you to understand what you're actually paying, keeping your dealer honest.

Simple interest car loans, also referred to as APR Loans — where APR stands for annual percentage rate — are the most common. They work like a traditional mortgage, through which you pay a combination of interest and principal every month and the interest is recalculated on the loan's balance every month. As you pay the principal on the loan down, you owe less interest, letting more of your payment go to principal.

Pre-computed loans front-load the interest. These loans are typically issued by used car lots and frequently are offered to borrowers with weak credit. In a pre-computed loan, you pay most of the loan's interest up front before making any meaningful payment of principal. If you pay the loan off early, you'll still end up paying all or almost all of the interest that you would have paid if you didn't pay it off early.

The interest rate on your loan depends on many different factors. Generally, longer-term loans carry higher rates, since there is more risk to the lender. In addition, your credit score will usually determine your rate, since lenders want extra compensation for the risk of lending to you if you do not have excellent credit. Your loan rate will also vary based on your income and on how much you are willing to spend as a down payment for your car.

One way that carmakers try to motivate you to buy their cars is to offer low-rate promotional financing offers, like 0.0 percent or 2.9 percent loans. These promotional rates are usually much better than what you can get from a bank or the dealer, but they frequently require you to give up a manufacturer-subsidized discount on the car. Before taking a low-interest rate loan, ask whether you may have a discount instead. In some cases, you save more by taking the cash discount so that you borrow less money even if you have a higher-rate loan.

On a simple interest loan, the amount you borrow works together with your interest rate and loan term to determine your payment. For example, if you take out a $20,000 36-month car loan at 4.05 percent, your monthly payment will be $590.92. Lengthening your loan to 48 or 60 months decreases your payment to $452.03 or $368.78, respectively.

The lower payment of the longer loan comes at a price, though. You'll pay more interest over the life of the loan. Going from a 36-month loan to a 60-month loan almost doubles the amount of interest you pay, from $1,273 to $2,127. This rule also works with other variables. You could keep the payment and the rate the same, but borrow more money by extending your loan's term. Borrowing $20,000 at 4.05 percent for 36 months has the same monthly payment as borrowing $32,047 at 4.05 percent for 60 months, for example.