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Simple-interest loans are some of the most common types of car loans, so if you're in the market for an auto loan, it's important to understand how they work. By learning about simple-interest loans, you could recognize opportunities to cut costs and potentially save some money on your next vehicle.
What Is a Simple-Interest Car Loan?
Simple-interest car loans are loans that are not compounded, meaning that interest is calculated solely off the principal amount borrowed from your lender, rather than the principal plus interest already accumulated. Simple-interest loans are common in auto loans and short-term loans, but some mortgages also use this interest structure.
Simple Interest vs. Compound Interest
Compound interest differs from simple interest in key ways, including the monetary figure used to calculate interest. While simple-interest car loans calculate interest based on the principal amount of your loan, compound interest is calculated using your principal plus any unpaid interest. Simple-interest loans also use a fixed interest rate, while compound-interest rates are variable.
This means that over the course of a compound-interest loan, you could be paying hundreds, if not thousands, of dollars more in interest — even if you make on-time payments. Compound interest also increases significantly more than simple interest when your loan is lengthened or your compound rate increases. Each time your interest compounds, you end up paying more.
How to Calculate Simple-Interest Auto Loans
To find your interest payment, your lender will multiply principal by your daily interest rate, which is generally your interest rate divided by 365 or 360 days — depending on what's selected by your lender.
For example, if you had an auto loan of $20,000 with a 8% interest rate over four years, your estimated monthly payment would be $488.26. Over the period of the auto loan, you would pay a total of $3,436.41 in interest.
However, this calculation becomes more complex when determining your amortization schedule, which establishes how your monthly payment is split between your principal and your interest. Your exact amortization schedule will depend on your principal, interest rate, and loan term, so consider using an online auto-loan calculator to best estimate your potential payments.
Simple-Interest Loans Help Reduce Interest Over Time
A top benefit of simple-interest car loans is that borrowers can potentially reduce the total interest over the length of their loan by paying off more of the principal each month, which adjusts the interest. In the beginning of your loan's term, much of your monthly payment goes toward interest. However, over time your payment will shift to cover more of your principal than interest.
Simple-interest car loans reevaluate your remaining principal against your interest rate monthly to evenly distribute your interest over the period of your loan. With this model, the more of your principal you pay off per month, the less interest will be accrued over time — leading to lower interest overall. Here are a few ways to reduce your interest by making proactive payments toward your principal:
- Paying more than the minimum payment. Paying off your principal faster reduces the time it takes to pay off your loan, thus reducing your total interest owed.
- Making additional payments. Any additional payments you make toward your principal will reduce your total interest and pay off your principal faster.
- Paying off your principal early.The sooner your principal is paid, the less interest you'll have. But depending on the terms of your loan, you may be subject to a prepayment penalty. For specifics, you'll have to check with your lender.
Reducing the amount of interest you pay on your auto loan ultimately comes down to paying off your principal as quickly as possible. Since interest is calculated over time, on-time payments and overpayment can be great strategies to save money in the long term.
Late Payments Result in Higher Interest and Potential Fees
Just as you can reduce your total interest by paying on time or early, you risk increasing your interest payment by paying late. Late payments stretch out your loan schedule, forcing you to pay more interest over a longer period of time.
Consider the consequences of being late or altogether missing a monthly payment. Typically, lenders will offer a one-time grace period of 10 to 15 days and charge a late fee of up to $50. However, payment delinquency can lead to your credit taking a hit, which could affect your score for as long as seven years after the missed payment. Fully missing one or more payments can also lead to more serious consequences, such as repossession of your vehicle or even a lawsuit. If you're in danger of missing a car-loan payment, it's a good idea to quickly seek loan deferment or refinancing, even if it means paying more interest.
Another drawback of late payments is the possibility of additional fees. Depending on your lender, you may incur late fees that increase your monthly payment and the overall cost of your car loan.
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