How Interest Rates Work on Car Loans

Some people take advantage of financing deals from the automaker when they want to buy a new car. Others go to outside lenders. They'll have to pay interest on the loan in either case. Getting an auto loan for a longer term with lower interest rates might keep the monthly bill below a budget-busting level can be tempting but is that a good idea? A longer-term loan can lower the monthly payment but the total interest paid over the life of the loan is greater.

Three Big Factors About Car Loans

The average price of a new car is $46,085 as of February 2022, up 11.4% from a year ago. So it's no surprise that consumers increasingly finance their purchases with longer-term loans. The average auto loan term is about 70 months while the most common is 72 months.

Consider three big factors before taking out an auto loan.

Auto Loan Interest Rates

Auto loan interest rates change daily and vary widely. Before you enter a showroom, check the current auto loan rates. You might consider getting pre-approval from a bank or credit union before shopping for a car. Consumer advocates say that an auto salesman might give you either a good price on the car or a good deal on the financing, but not both. In any case, you want to be informed about the best possible deal on a loan.

Simple Interest Costs

Auto loans carry simple interest costs, not compound interest. The borrower agrees to pay the money back plus a flat percentage of the amount borrowed. The interest earns interest over time with compound interest so the total amount paid snowballs.

Amortization

Auto loans are amortized just like mortgages. The interest owed is front-loaded in the early payments. Homeowners who owed more than their homes were worth for resale were said to be underwater during the housing price collapse. Car buyers can also be driving underwater unless they make a hefty down payment or offer a late-model trade-in because a car depreciates steeply in value as soon as it's driven off the lot. 

Examples of Car Loan Interest Rates

The real cost of a car is determined by the car loan you choose. The car, the down payment, and the amount to be financed are the same in all these examples:

• Original Car Price: $46,085
• Down Payment of 10%: $4,608
• Amount Financed After Down Payment: $42,199

Five-Year Loan at 4% Interest

If, after making a 10% down payment upfront, the balance of $42,199 is financed for five years at 4%, the monthly payment would be $746.38. The total paid would be $44,783.09 in monthly payments, including all of the interest, which amounts to $4,255.09. If we include the initial down payment of $4,503, the total cost of the car would be $49,286.09.

Eight-Year Loan at 4% Interest

If, after making a 10% down payment upfront, the balance of $40,528 is financed for eight years at 4%, the monthly payment would be $494.01. The total paid would be $47,424.67 in monthly payments, including $6,896.67 in interest. If we include the initial down payment of $4,503, the total cost of the car would be $51,927.67.

Five-Year Loan at 6% Interest

The interest rate that you get on the loan has a dramatic impact on these numbers. Consider how the numbers change if you had to pay a 6% rate instead of 4% for the same car. Here are the financial details again:

• Original Car Price: $45,031
• Down Payment of 10%: $4,503
• Amount Financed After Down Payment: $40,528

If, after making a 10% down payment upfront, the balance of $40,528 is financed for five years at 6%, the monthly payment would be $783.52. The total paid would be $47,011.19 in monthly payments, including interest of $6,483.19. If we include the initial down payment of $4,503, the total cost of the car would be $51,514.19.

Eight-Year Loan at 6% Interest

If, after making a 10% down payment upfront, the balance of $40,528 is financed for eight years at 6%, the monthly payment would be $532.60. The total paid would be $51,129.20 in monthly payments, including $10,601.20 in interest. If we include the initial down payment of $4,503, the total cost of the car would be $55,632.20.

You can run the numbers for yourself using the Investopedia Auto Loan Calculator.

Factors That Impact the Interest Rate

You'll. be a more informed car shopper if you know the factors that can affect the interest rate on your car loan. We've listed some of the most important ones below.

• Current Interest Rates: In a strong economic environment, interest rates tend to be higher. In weaker periods, they can be lower. If rates are high, consider putting off your purchase until they drop.
• Credit Scores: Good credit scores are attractive to lenders and can mean lower interest rates. Conversely, lower credit scores can mean offers of loans with higher interest rates.
• Down Payment: The amount you can pay upfront for a car can affect your loan's interest rate. The more you put down, the lower the rate you may get because less is at risk for the lender. With small down payments, lenders may charge higher rates due to the risk of default on a larger loan amount.
• Term of Loan: Rates vary depending on a loan's term. Longer-term loans can come with higher interest rates.
• Lender Type: If you have a choice, consider a car loan from a credit union. Normally, credit unions offer more attractive rates on car loans than banks. Similarly, take a look at what's on offer in the finance department of the carmaker. It may offer specials that include lower interest rates.
• New or Used Cars: Whether a car is new or used can affect the interest rate on a loan for it. Rates on loans for used cars are typically higher than on loans for a new car.

Tips on How to Pay Less Interest

You don't have to accept the rate that's given to you. In fact, there are ways you can avoid overpaying interest. You just have to know what to look for and how.

• Shop Around: Look at multiple lenders for attractive or time-limited offers on financing. You may find some great deals on rates and more depending on your credit score and buying demand. The interest rate environment, of course, also plays a big role in this, too.
• Time Your Purchase: If the economy is hot and rates are strong, consider waiting until the buying environment cools down. You may find lower-priced cars as well as better rates.
• Opt for a Shorter Term: Can you swing a higher monthly payment? The numbers show that shorter loan terms mean you'll pay less in total interest over the life of your loan.
• Refinance: If the loan you've already got has a high rate, look for an opportunity to refinance your loan if interest rates decrease or if your credit score improves.
• Boost Your Credit Score: If your score is low or even average, take the necessary steps to improve it. The higher your score, the better the rate you'll be offered. Even a small increase may help cut the interest you pay on a car loan.
• Buy a Less Expensive Car: Be realistic about the vehicle you need, what you can afford, and how much debt you really want to take on.

The Bottom Line

Choosing a car loan is always a trade-off. If you’re on a tight budget, a lower monthly bill is an attractive option, but it means more monthly payments and a higher real price for the car. If you want to pay the best price for the car and a faster path out of debt, you’ll need to manage a hefty monthly payment.