What is an interest rate?
Let’s start first with the basics of understanding what an interest rate is. The interest rate is the rate at which a lender will charge for you to borrow the funds from them. This rate is a percentage of the loan amount, so the amount you pay in interest will be based off the principal balance of the loan.
Most lenders will charge interest on auto loans based on an amortization schedule, rather than a simple interest method. This means that the monthly payment of the loan will remain the same each month, but the breakdown of how that payment is applied by the lender will change over the life of the loan. Typically the first payments toward your loan will largely be used to cover the interest on the loan while the final payments of your loan will be more focused on paying down the principal balance of the loan.
How do you calculate the loan interest?
While some lenders will actually provide a breakdown so you can see how much of each auto loan payment will go toward the interest, there is a simple way for you to do this on your own.
- First, you’ll need to divide your interest rate by the number of auto loan payments that will be made that year. If you are making monthly payments, this will be 12 payments.
- Take this number and multiply it by the amount remaining on your loan balance. This will give you the amount of interest that will be part of your loan payment.
- Next, you’ll subtract this interest amount from your monthly payment amount. The remaining amount will show you how much of your payment will be paid towards the principal loan balance. This amount will be subtracted from the outstanding loan balance.
- If you want to continue this process for following months, you will follow the same steps but with a decreasing loan balance each month.
Here’s an example to show how you would calculate the interest if you have a 3 percent interest rate on your auto loan with a balance of $4,000 and monthly payments of $200.
- Divide 0.03 (the interest rate) by 12 (the number of payments in a year), which gives you 0.0025.
- Multiply 0.0025 by the $4,000 loan balance. This is $10. This means that $10 of your auto loan payment goes toward interest.
- Subtract the $10 from your $200 monthly payment and you’ll get will know that you are paying $190 toward your monthly payment.
- To calculate the next month, you’ll use the new loan balance of $3,810 and continue the steps.
Things that impact your auto loan:
There are a few factors that can affect your auto loan, your monthly payment, and how much you’ll pay over the lift of the loan. Here’s a look at some of those factors:
The actual amount you borrow for your loan will have a large impact on your payment and how much you’ll pay back interest. Larger loans will typically mean a larger payment and/or paying more interest on the loan.
Your interest rate will also impact your payment and will especially determine how much interest you’ll pay over the life of the loan. Interest rates are heavily influenced by your credit score, so having a good credit score can help you get the lowest interest rate and save money on the loan.
The loan term is how long the loan will last until it has been paid off. A shorter loan term length may mean higher payments, but you’ll pay less in interest. In contrast, a longer loan term length may mean lower payments, with a larger amount paid in interest throughout the loan.
Related: Benefits of Paying Off a Car Loan Early
What can impact your interest rate?
Having a lower interest rate can save you money over the life of your loan. While the type of loan you get will determine what rates are available, the biggest factor that will impact your interest rate is your credit score. Your credit score will determine which interest rate you qualify for, with the highest credit scores receiving the lowest interest rates.
Check out these tips to help you secure the best interest rate.