How Interest Rates Work On Car Loans

Getting an auto loan for a longer term with lower interest rates may keep the monthly bill below a budget-busting level, but is it a good deal for you?

To answer that question, you need to understand how interest rates on car loans work.

The average price of a new car is $33,652 as of June 2016, up 2% from June 2015, so it’s no surprise that consumers increasingly finance their purchases with longer-term loans. The average auto loan term is at a record 68 months as of Q1 2016. 

But here are the three big factors to consider before taking out your own auto loan:

• Auto loan interest rates change daily, and vary widely. Before you enter a showroom, check the current rates posted at BankRateMonitor.com. 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 what a “good deal” on a loan currently is. (See 6 Ways To Cut The Cost Of Your Car Loan.)
• Auto loans include simple interest costs, not compound interest. This is good. The borrower agrees to pay the money back, plus a flat percentage of the amount borrowed. (In compound interest, the interest earns interest over time, so the total amount paid snowballs.)
• Auto loans are “amortized.” As in a mortgage, the interest owed is front-loaded in the early payments. During the housing price collapse, homeowners who owed more than their homes were worth for resale were said to be “underwater.” Similarly, car buyers can be driving "underwater" for a long time, unless they had a hefty down payment or a late-model trade-in because a car depreciates steeply in value as soon as you drive it off the lot. 

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

• A 4% loan for a 5-year period would cost $557.78 a month. At the end of that time, you would have paid $33,466.80 in monthly payments. Add in the $3,365.20 down payment and the real cost of the car will be $36,832.
• If you stretched that loan to eight years, the monthly payment would drop to $369.18. At the end of that time, your loan payments would total $35,441.28. Including the $3,365.20 down payment, the real cost of the car rises to $38,806.48.

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. 

• The monthly payment on a 5-year loan for $30,287 at 6% interest would be $585.53. You would pay $35,131.80 in monthly payments. Throw in the 10% down payment, and the car costs $38,497.
• If stretched to an 8-year term, the monthly payment on that $30,204 loan at 6% interest drops to $398.01 a month. The loan payments would total $38,208.96. Add in the 10% down payment and the car costs $41,574.16.

You can run the numbers for yourself using BankRateMonitor.com’s loan calculator. 

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. 

For further reading, see Investopedia’s tutorials, The Complete Guide To Buying A New Car and The Complete Guide To Buying A Used Car.