How Auto Loan Interest is Calculated?

Introduction

When you finance a car purchase, the auto loan interest is one of the biggest costs you’ll incur. Understanding how auto loan interest is calculated can help you get the best rate and terms when financing your next vehicle.

How Auto Lenders Calculate Interest

There are a few key factors that determine how auto loan interest is calculated:

• Loan principal – This is the amount you actually borrow to buy the car. The higher the principal, the more interest you’ll pay over the life of the loan.
• Interest rate – Expressed as a percentage, this is the cost to borrow money. The higher the rate, the more interest you’ll owe.
• Loan term – Longer loan terms mean you’ll pay more total interest because you’re borrowing for a longer period.

Auto lenders use these factors to calculate your auto loan interest charges each month using the following formula:

Loan principal x Interest rate x (Number of days in billing cycle / Number of days in year)

So how auto loan interest is calculated comes down to the loan details entered into this formula each month.

Key Factors That Determine Your Auto Loan Interest Rate

Several variables affect the specific interest rate you’ll be offered on an auto loan, including:

• Credit score – Borrowers with higher scores generally get lower rates.
• Down payment – Larger down payments reduce the loan amount so lenders charge lower rates.
• Loan term – Shorter terms often have lower rates.
• Vehicle – New or used, make and model can influence rates.
• Lender – Rates vary amongst banks, credit unions and dealers.

Generally, the higher your credit score, the larger your down payment and the shorter your loan term, the lower the interest rate you can qualify for. Shopping among multiple lenders also helps secure a competitive APR.

How the Loan Term Impacts Interest Charges

The loan term you choose dramatically impacts your total finance charges. Consider two loans of $30,000:

• 5-year loan at 5% APR = $5,463 total interest
• 8-year loan at 6% APR = $9,658 total interest

Despite the higher APR, the shorter 5-year term results in nearly $4,200 less in interest compared to the 8-year loan. That’s because you pay off the balance quicker, reducing the amount of interest that accumulates.

Strategies to Reduce Auto Loan Interest

Here are some tips for getting the lowest auto loan interest rate possible:

Boost your credit score – Maintaining a score over 740 can help qualify you for the best rates. Pay bills on time and lower credit utilization.

Shop lenders – Compare rate quotes from banks, credit unions and dealers. Avoid applying repeatedly as hard credit inquiries can impact your score.

Put down a larger down payment – A 20% down payment results in a lower loan amount so lenders charge lower rates.

Choose a shorter term – Opt for a 36 or 48-month loan instead of 60 or 72 months to slash interest charges.

Apply a trade-in – The equity in your current vehicle reduces the amount you need to borrow.

Make extra payments – Paying a little extra each month goes directly to the principal, reducing your interest expense over the long run.

The Impact of Your Credit Score on Interest Rates

Your credit score has a direct correlation to the auto loan interest rate you can qualify for. Here’s how key credit score tiers impact how auto loan interest is calculated on a $25,000 used car loan:

Credit Score	Interest Rate	Total Interest Paid
760+	3.99%	$1,948
720 – 759	5.99%	$3,193
680 – 719	8.99%	$4,714
640 – 679	11.99%	$6,370
Under 640	15.99% or higher	$8,215+

As the table illustrates, just having a higher credit score of 760+ can save over $6,000 in interest charges compared to someone with a score under 640. This demonstrates the value of optimizing your credit before applying for an auto loan.

Other Auto Loan Costs Beyond Interest

When budgeting for a car purchase, be aware of additional costs beyond just the auto loan interest:

• Fees – Most loans have origination fees to process the application, documentation fees, etc. These range from $75-$400 on average.
• Sales tax – Due when you register the vehicle, varies by state. Typically ranges from 2%-7% of the purchase price.
• Dealer prep – Covers getting the vehicle ready for sale, around $500-$1000.
• Title and registration – Typically around $400 depending on the state.
• Insurance – Required for any financed vehicle, rates depend on many factors. Budget $1,000-$2,000 per year.

Factor these fees into your total cost calculations when shopping for your new vehicle and auto financing.

The Bottom Line

When you finance a car, interest charges account for a significant portion of the total repayment amount. Know how auto loan interest is calculated based on the loan amount, APR, terms and your credit so you can make informed decisions. Improving your credit score, putting more money down, choosing a shorter loan term and shopping lenders can help secure the lowest interest rate for your situation.

How auto loan interest is calculated may seem complicated at first, but just remember it comes down to the loans principal, APR, length of the loan term and your credit score. With strong credit and smart negotiating, you can get reasonable auto loan interest and affordable monthly payments. Keeping an eye on how auto loan interest is calculated for your particular situation makes financing a vehicle purchase easier.

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