You may have started researching financing options if you are in the market for a new car. Auto loans are readily available through traditional banks, credit unions and online lenders, but they’re not all the same. Beyond the varying loan terms each lender offers, you’ll also need to consider how they assess interest on auto loan products.
Simple interest auto loans are common and come with several benefits that make them an attractive option. Plus, they are more affordable than compound interest loans, which charge you interest on top of interest.
How a simple interest auto loan works
Simple interest auto loans come with a fixed monthly payment. However, the amount applied to interest each month is based on the outstanding principal balance. Here’s an example of how simple interest auto loans work:
- Assume you get approved for a four-year $36,000 auto loan with an interest rate of 6 percent.
- You’ll pay $8,640 in interest over the life of the loan. This figure is calculated by multiplying the principal loan amount, interest rate and loan term ($36,000, 0.06 and 4).
To find the amount of interest due each month, use the following formula:
- Find the interest rate divided by 365 days.
- Multiply that figure by the beginning balance for the month, then multiply that by the number of days between payments.
- If you take out the loan in November, you’ll pay $177.53 in interest for the month — $36,000 x (.06 / 365) x 30.
The monthly payment on this loan is around $845. So, $667.47 will be applied to the principal balance in the first month, and the remaining $177.53 will go towards interest. In December (or month two), you’ll pay $180.05 in interest and $664.95 towards the principal.
How it differs from a precomputed interest auto loan
If you take out a precomputed interest auto loan, the lender calculates the interest you’ll pay over the loan term. It’s added to the principal loan amount to generate the monthly payment figure. So, repaying the loan before the term ends won’t save you money since interest is already factored into the amount you owe when you take out the loan.
Simple interest auto loan benefits
Simple interest auto loans come with a few key advantages that make them a popular option:
- More affordable payments: Since the amount of interest you pay each month is only based on the principal balance, you’ll get lower monthly payments than you would with a compound or precomputed interest loan.
- Sizable cost savings: If you decide to pay the loan off early, you could save a bundle in interest. For example, if you take out a five-year, $25,000 auto loan with a 5 percent interest rate, the monthly payment will be $471.78. Plus, you’ll pay $3,306.87 in interest over the loan term. But if you pay an extra $100 each month, you’ll pay the loan off in 49 months and save $651.04 in interest.
How to save on a simple interest auto loan
Use these strategies to save money on a simple interest auto loan:
- Pay more than the minimum: Paying extra each month or even doubling up on the payments can help you reduce the principal balance faster and pay off the loan early. But before using this strategy, confirm that the lender doesn’t assess prepayment penalties.
- Make timely payments: If you fall behind on loan payments, you could be charged late fees and accrue additional interest on your simple interest auto loan.
- Sign up for autopay: Doing so prevents you from having to worry about missed payments, unnecessary fees or adverse credit reporting, which could be costly over time.
Simple interest auto loans are a viable financing option for your next new ride, even if they aren’t the most common. You will enjoy a fixed monthly payment and the ability to save a bundle in interest if you can pay your loan off early.
When you’re ready to move forward, shop around to find reputable lenders that offer simple interest auto loans. And make sure to prequalify with at least three lenders before signing on with one.