How Is Your Auto Loan Interest Calculated?
If you have a car loan, you probably know that part of your monthly payment goes to interest. However, how that interest is calculated and translates to your monthly payment is not always clear.
Knowing how your payments are determined, and how this relates to your APR or interest rate, can make it easier to be a savvy consumer. This can be especially helpful when it comes to making early payments on your car loan.
Key Auto Loan Terms to Understand
To understand how your auto loan interest is calculated, you’ll want to understand a few key definitions.
APR vs. Interest Rate
APR and interest rate are two important figures to know when trying to understand how your interest is calculated.
APR stands for annual percentage rate and is a figure that represents the total cost to borrow money. This includes your interest rate but also includes any other fees associated with the loan. It’s a number that lets you compare loans – because it covers all the money that you’ll pay in a year to have that loan.
The interest rate by itself is only the amount charged for borrowing the money. It does not include any fees or any additional costs.
Simple vs. Compound Interest
Simple interest is charged only on the principal that you borrow, while compound interest is charged on both the principal and the interest that accrues. In other words, compound interest grows over time, while simple interest does not. Most auto loans, like those offered at OUCU, use simple interest.
Amortization means spreading your payments out over a set period of time. Towards the beginning of your car payment schedule, a significant portion of your payment goes towards interest. As you pay it off, less and less of your car payment will be made up of interest, and more of it will be made up of principal.
Fixed vs. Variable-Rate Loans
Depending on your specific financing, your auto loan interest is calculated differently. One of the key factors that affect this is whether your loan is fixed-rate or variable-rate.
A fixed-rate loan means that the interest rate will remain the same for the entire life of the loan. This can give peace of mind to borrowers because they won’t have to worry about their rate going up. OUCU offers fixed-rate auto loans only.
A variable-rate loan is one where the interest rate can change, typically fluctuating with a specified financial index. Most variable-rate loans have cap limiting how much the rate can go up or down each year. If you’re considering a variable-rate loan, be sure to find out what the caps are.
How Auto Loan Interest Is Calculated
Your interest will be calculated in one of two ways, either simple interest or precomputed interest.
Most auto loans, especially those with a variable rate, are simple interest loans. Simple interest is calculated each time your auto loan is due. It is based on the amount of principal that you owe at the time. This is why so much of your payment is made up of interest at the beginning of your loan– because you owe more on the car than you do towards the end.
Precomputed interest is slightly different. In this case, the total interest you will owe is calculated at the time you take out the loan. That amount is then divided amongst all the months in the car loan’s term.
Essentially, the difference is that with simple interest, the amount of interest you pay each month changes. With precomputed interest, the amount you pay each month is the same.
How Interest Calculation Affects Early Payments
If you are trying to pay off your car loan early, it is useful to know how your interest is calculated.
If your interest is calculated in the simple interest way, then additional car payments on your principal can reduce the interest you pay. However, if your interest is precomputed, additional car payments will not likely save you money. Rather, you will still pay the same amount of interest each month as it is determined based on a pre-calculated schedule.
Saving Money by Getting the Best Interest Rate
Regardless of how your interest is calculated, one of the best ways to save money is to get a car loan with the best possible interest rate.
To do this, start early and shop around. Comparing interest rates among various lenders allows you to find the best rate and avoid getting sucked into an overpriced car loan.
Once you find several car loans that you like, you can apply for pre-approval. Pre-approval can help you set a budget and give you bargaining power at the dealership. It’s highly recommended to get an auto loan pre-approval before car shopping!
Start Shopping Car Loans Today
When you shop for car loans, you’ll want to look not only at a variety of lenders but at a variety of financial institutions. Credit unions like Ohio University Credit Union offer excellent, competitive rates — click below to see for yourself!
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