You may have started researching financing options if you are looking for a new car. Auto loans are readily available from traditional banks, credit unions, and online lenders, but not all are the same. Beyond the different loan terms offered by each lender, you’ll also need to consider how they rate interest on auto loan products.
Simple interest car loans are common and have several advantages that make them an attractive option. Plus, they’re more affordable than compound interest loans, which charge you interest on top of interest.
How a simple interest car loan works
Simple interest car loans come with a fixed monthly payment. However, the amount applied to interest each month is based on the outstanding principal balance. Here is an example of how simple interest car loans work:
- Say you’re approved for a four-year $36,000 car loan with an interest rate of 6%.
- You will pay $8,640 in interest over the life of the loan. This figure is calculated by multiplying the principal amount of the loan, the interest rate and the term of the loan ($36,000, 0.06 and 4).
To find the amount of interest due each month, use the following formula:
- Find the interest rate divided by 365 days.
- Multiply this figure by the starting balance for the month, then multiply it by the number of days between payments.
- If you take out the loan in November, you’ll pay $177.53 in interest for the month, or $36,000 x (0.06/365) x 30.
The monthly payment on this loan is around $845. Thus, $667.47 will be applied to the principal balance in the first month, and the remaining $177.53 will go to interest. In December (or the second month), you will pay $180.05 interest and $664.95 principal.
How is it different from a pre-calculated interest car loan
If you take out a pre-calculated interest car loan, the lender calculates the interest you will pay over the term of the loan. It is added to the principal loan amount to generate the monthly payment figure. So, paying off the loan before the end of the term won’t save you money since the interest is already factored into the amount you owe when you take out the loan.
Advantages of the simple interest car loan
Simple interest car loans have a few key benefits that make them a popular option:
- More affordable payments: Since the amount of interest you pay each month is based solely on the principal balance, you’ll get lower monthly payments than you’d get with a compound or pre-calculated interest loan.
- Considerable savings: If you decide to pay off the loan early, you could save a lot of interest. For example, if you take out a $25,000 car loan for five years with an interest rate of 5%, the monthly payment will be $471.78. Plus, you’ll pay $3,306.87 in interest over the life of the loan. But if you pay $100 more each month, you’ll pay off the loan in 49 months and save $651.04 in interest.
How to save on a simple interest car loan
Use these strategies to save money on a simple interest car loan:
- Pay more than the minimum: Paying extra each month or even doubling the payments can help you reduce the principal balance faster and pay off the loan sooner. But before using this strategy, make sure the lender does not impose prepayment penalties.
- Make timely payments: If you are late on your loan payments, you may be charged late fees and additional interest may be charged on your simple interest auto loan.
- Sign up for automatic payment: This saves you from having to worry about missed payments, unnecessary fees or unfavorable credit reports, which could be costly over time.
Simple interest auto loans are a viable financing option for your next new vehicle, although they are not the most common. You will benefit from a fixed monthly payment and the possibility of saving a bundle in interest if you can pay off your loan sooner.
When you’re ready to move on, shop around for reputable lenders who offer simple interest auto loans. And be sure to prequalify with at least three lenders before signing with one.