how car loans workAbout principal and interest

If you purchase a new or used car with a loan, you agree to pay off the loan amount (principal) over a specified number of months. But you also agree to pay a finance charge, or interest, for the privilege of using the bank’s (or finance company’s) money for your purchase.

The amount of finance charge that you pay is the interest rate, which is set by the bank or finance company based generally on national lending rates and more specifically on your credit score. Interest rate is expressed as a annual percentage rate (APR), such as 5.5%.

Interest rates can be different for the same loan amount

Wholesale lending rates are lower now than in recent years but banks and finance companies, as well as dealers, can boost these rates (called reserve) for their customers. You can check current national average auto loan rates at Bankrate.com. At the time of this writing, the average 36 month new-car loan rate was 3.93% — very low. But automotive consumers may pay higher rates depending on the lender, dealer reserve, and the customer’s credit score.

Auto buyers should always know their most recent credit score before going car shopping. Otherwise, dealers know more about you than you know about yourself, which could lead to some unpleasant surprises. Getting your credit score is easy enough online. What’s your FICO score? Find out now when you check your credit report for $1 at Experian.com!

Auto manufacturers frequently offer limited-time promotional rates of 1.9%, 0.9% or even 0.0% on selected makes and models. These are real bargains but are usually limited to “highly qualified” customers — customers with good credit scores.

Each monthly car loan payment is made up partly of principal and partly of interest. Although the amount of each payment is the same every month, the amount of principal and amount of interest changes each month.

The reason is that as you pay down the loan amount, the amount of interest decreases each month. Therefore, at the beginning of a loan, you pay less principal each month — and more interest —than later in the loan term.

Example Car Loan

As an example, using our Auto Loan Calculator, let’s look at a typical car loan for a $20,000 car for 48 months with $2000 down payment — which means we are actually financing $18,000. Let’s also assume the interest rate is 5.5%.  We will plug in our numbers and also select the “Show Payment Tables” option so that we can see exactly how the amortization of our loan payments works.

The first thing we see in the results of the calculation is that our monthly payment is $418.62 — every month. We also see that the amount of interest we’ll pay over the entire 48 months of the $18,000 loan is $2093.59. The total of all our payments will therefore be $22,093.59 ($18,000 plus $2093.59).

Notice that your first payment in month #1 is made up of only $336.12 principal and $82.50 interest, while your last payment in month #48 contains $416.71 principal and only $1.91 interest.

Another interesting observation is that by the time you’ve reached the halfway point in your loan at 24 months, you’ve already paid $1540.18 in interest, almost three quarters of the $2093.59 total for the entire loan term. But at the same time, you’ve paid only $8506.62 — less than half of your $18,000 principal.

What this means

It means that if you decide to sell or trade your car halfway through your 4 year loan, you still owe more than half of your loan amount, and the bank or loan company already has most of their interest money. If you buy another car with another loan, you begin paying up-front interest all over again. Doesn’t seem quite fair, but that’s the way it works.

Looking at it another way, by ending your loan early at 2 years, you pay an effective interest rate of over 16%, almost three times the 5.5% rate you thought you were paying. It simply is not smart to end a car loan early unless you are very near the end of your term.

If you need a car loan

If you need an auto loan, whether buying from an individual or a dealer, you should shop around for the best rates and dow payment requirements at local banks, credit unions, and online at respected lenders such as Auto Credit Express.

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