How interest rates work on car loans

May 7, 2019

If you get a car loan for a longer period with lower interest rates, the monthly bill may remain below a budget-engaging level, but is this a good deal for you?

To answer that question, you must understand how the interest on car loans works.

Three major factors about car loans

Three major factors about car loans

The average price of a new car is $ 33,652 from June 2016, a 2% increase over June 2015, so it’s no surprise that consumers are increasingly financing their purchases with long-term loans. The average car loan term is with a record of 68 months from Q1 2016.

But here are the three important factors that you should consider before taking out your own car loan:

  • The interest rate on car loans changes daily and varies greatly. Before entering a showroom, check the current rates posted at Bank rate. You can consider asking permission from a bank or a credit union before you go shopping for a car. Consumer advocates say a car salesman can give you a good price for the car, or a good deal for financing, but not for both. In any case, you want to be kept informed of what a ‘good deal’ on a loan is at present. (See 6 ways to reduce the cost of your car loan. )
  • Car loans include simple interest costs, not compound interest. This is good. The borrower agrees to repay the money, plus a fixed percentage of the loan amount. (In compound interest, the interest earns interest over time, so the total amount of snowballs paid.)
  • Car loans are “written off.” Just like with a mortgage, the interest due is preloaded in the early payments. During the collapse in house prices, it was claimed that homeowners who owed more to their homes were worth resale. “In the same way, car buyers can drive ‘under water’ for a long time, unless they have a substantial down payment or a late-model trade-in because a car drops sharply as soon as you drive it out of the field.

Crunching the Numbers

Crunching the Numbers

The examples below show how the actual costs of a car are determined by the car loan you choose. In any case, the car, the down payment and the amount to be financed are the same: the average price is $ 33,652. The down payment is 10%. The amount funded is $ 30,287.

  • A 4% loan for a 5-year period costs $ 557,778 a month. At the end of that period you would have paid $ 33,466,800 in monthly payments. Add the down payment of $ 3, 365.20 and the actual cost of the car is $ 36,832.
  • If you extended that loan to eight years, the monthly payment would fall to $ 369. 18. At the end of that period, your credit payments would total $ 35,441. 28. Including the down payment of $ 3, 365.20, the actual cost of the car rises to $ 38, 806. 48.

Your monthly payment – and the total

Your monthly payment - and the total

The interest rate you get on the loan has a dramatic impact on these numbers. Consider how the numbers change if you were charged a rate of 6% instead of 4% for the same car.

  • The monthly payment for a 5-year loan for $ 30,287 at an interest rate of 6% would be $ 585. 53. You would pay $ 35, 131, 80 in monthly payments. Throw in the 10% deposit and the car costs $ 38,497.
  • If this is extended to a term of 8 years, the monthly payment on that loan drops from $ 30,20 with an interest rate of 6% to $ 398.01 per month. The loan payments would amount to a total of $ 38, 208. 96. Add the 10% deposit and the car costs $ 41, 574. 16.

You can execute the numbers yourself with Bank rate’s loan calculator.

The bottom line

Choosing a car loan is always a consideration. If you have a tight budget, a lower monthly bill is an attractive option, but this means more monthly payments and a higher real price for the car. If you want to pay the best price for the car and get a faster path out of debt, you have to make a hefty monthly payment.

For further information, see the Investopedia tutorials, The complete guide to buying a new car and The complete guide to buying a used car.

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