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How Does Interest on Car Loan Work, Mostly Depends on You

When you plan to buy a new car, you are probably thinking about a car loan. Taking a loan will allow you to pay it off over some fixed period, plus interest. That way, you do not have to pay the entire cost upfront. But how does interest on a car loan work?

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Loan Interest

Taking a loan means that you make a legal contract between you and a lender. It could be a bank or a credit union. The collateral is the car you want to buy so that if you default on your payments, the lender has the right to take away your car.

By making a loan, you will have to pay some interest to the lender. The rate will be stated upfront and sometimes it is negotiable. However, some factors can influence this loan rate, such as your credit score or the kind of car you like to buy.

The payment you make every month will go to the loan principal and cover the interest. So, by the end of the installment period, your total payment for the car will be the total of both the principal and the interest.

Example of How the Interest Work on Car Loan

To make it easier to understand, let’s take an example of a real-life situation to better demonstrate how does interest on a car loan work.

Let’s say that you want to buy a car that has a price of $32,000. Then you put a 10% down payment, which is $3,200. This means the remaining balance of $28,800 will be paid by taking a loan.

If you want to take a 60-month loan (five years), the lender gives you a 4.21% interest rate because you have a good credit score. By the end of five years, you will pay $3,187,77 in interest. Meanwhile, your monthly payment will be $533.13. So, in total, you will pay $31,987.77.

To make a comparison, let’s say you have a lower credit score, so the lender might give an interest rate of 11.33 percent. Then the monthly payment will be $630.93 each month for 60 months. By the end of five years, the total will be $37,855.92. The $9,055.92 of it is interest.

With that comparison, you will see that with the same amount of down payment and installment period, it is important to get the lowest interest rate possible. Because the total payment can make a big difference.

Factors that Influenced Interest Rate

There are several factors that the lender will look at to determine the right interest rate for you. Here is the list:

  • Credit score. Someone with an excellent credit score can get as low as a 3 percent interest rate while a very low credit score can reach as high as 14 percent.
  • Down payment. A bigger down payment can lower the interest rate. Because the lower down payment might make the lender believe that you have a higher risk of default.
  • Loan term. The shorter term of installment means that you will pay less interest. However, the lower term means lower monthly payment but you will pay more interest.
  • Type of vehicle. The interest rate for a new car is less than for a used car. Because it already depreciated, then the lender might see it as a higher risk than a new car.
  • Repayment schedule. This means the frequency of your payments. For example, if you pay twice a month then you will pay less interest compared to a single payment.
  • General car loan interest rates. This can change daily. Also, it will be depending on the type of lender, such as a commercial bank or an online lender.

How Do Lenders Calculate the Loan Interest?

So, how does interest on a car loan work, in terms of the method? There are two most common methods the lender uses to calculate loan interest. The method they use will influence the cost of the loan.

1. Simple Interest Loan

The lender calculates the interest based on the loan balance on the day of your car payment. This means the payment will be in a different amount of interest each month.

In most cases, the payment will be paid more to the interest at the beginning of the term. But toward the end, the payment will go toward the principal.

The downside with this method is that when you first start making payments, you owe more than the car is worth. This means you have negative equity.

2. Precomputed Interest Loan

How does interest on a car loan work by using this method? Turns out that the interest rate will be divided evenly over the payment term. That way, you will pay the same amount of interest each month. You will not save as much money with this method.

The Average Interest Rate for Car Loans

The average rate from commercial banks is usually around 4.85 percent for the 60-month installment for a new car. With the 72-month installment, the average interest rate is 5.19 percent. However, your personal factors such as the ones mentioned above will influence the rate as well.

So, how does interest on a car loan works? The answer is the type of car, your factors will play a huge part in determining the interest rate.

So, the key is to find the best interest rate. That means you have to go around and compare rates from a few lenders. Don’t decide without calculating it thoroughly. You can use a car loan from (DW)

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