Types of Interest Rates
The interest rate is the amount you will pay to the lender, and is essentially the cost of borrowing that money.
You will find the interest rate detailed as a percentage in the loan contract, and this percentage is based on the loan principal, otherwise known as the amount of the loan taken which goes down over time as it is paid.
In most cases, interest rates are calculated annually.
However, some lenders may calculate it for shorter periods like bi-annually or monthly.
Depending on the lender, car loans can charge interest in two ways:
- Interest Rate
- Annual Percentage Rate
Interest Rate
The Interest rate is the amount that the lender charges on the total outstanding amount of your loan, usually calculated annually.
For instance, if you get a car loan at an 8% interest rate, the lender will charge you $8 every year for every $100 of the principal amount.
So, if you spend $15,000 on purchasing a car, the lender will charge you $1,200 as interest (8% of $15,000 per year).
You can pay this interest as a one-time payment or speak with the lender and opt for a monthly schedule.
Not all lenders agree to this, and even if they do, they might increase the overall interest rate.
If you select a monthly-interest rate, it doesn’t make much of a difference.
Considering the aforementioned example, if a monthly-interest rate is applied, the lender will ask you to pay interest that is 1/12th of the annual interest rate.
That being said, it is better to find a car loan with a lower interest rate as it directly affects your monthly installments.
If you opt for a higher interest rate, might end up paying more than the actual value of the car.
Annual Percentage Rate (APR)
Unlike the interest rate, an annual percentage rate is quoted on the total amount.
This type of rate includes the standard interest rate on the debt, as well as all other costs involved with processing your loan.
For instance, you have a total loan of $20,000 (inclusive of fees) at 8% APR for 3 years.
Based on this, you will be paying $2,562.18 as total interest for amortizing the payments.
That means paying $7,520.73 per year for three years to clear the car loan.
The APR indicates the overall, bottom-line borrowing cost and typically makes it easier to directly compare lenders for the best rates.
Car Loans Are Amortized
Amortization is a banking process by which a debt is divided over time into a sequence of fixed payments.
You must pay off the interest and principal of the loan in different amounts per month, even though the total payment is the same for each cycle.
These car loans are designed to help borrowers pay off the total outstanding in full over a given amount of time.
Your regular loan payments don't change; the calculations simply work out the repayment and principal payments percentages per month until the total debt is paid.
To make it clear, the amount you pay monthly on a car loan consists of:
- What the lender gets paid (interest)
- Paying off a portion of the total outstanding (principal amount)
Hence, you’ll notice that the monthly payments on most car loans are higher for the first few months, and it gets lower over time.
For instance, if you have a 5-year car loan of $20,000 with a 5% interest rate and monthly payments, your 1st month’s interest will be $377.42. When you make the payment, a major portion of it will be subtracted from the principal outstanding and the rest will be the interest.
So, $294.09 will add up to the principal and $83.33 to the interest. This process keeps continuing till the 60th month.
How to Get Better Interest Rates
Finding a better interest rate depends on many factors. The qualification criteria, too, vary from lender to lender.
Some of the most important things that lenders consider are:
- Credit Score – The higher your credit score, the lower your car loan’s interest rates will be.
- Loan Term – If you opt for loans that have extended terms, you will end up paying higher interest rates.
- Vehicle Type – A lot depends on the total cost of the vehicle, as well as its model and make. The interest rate also varies on a new car loan and a used-car loan. Make sure that you speak with the lender about your preferences.
- Down Payment – You can get a lower interest rate depending on the loan-to-value (LTV) ratio. If you make a higher down payment, the lender will happily agree to settle for a lower interest rate, as there will be less risk involved.
Conclusion
Understanding interest rates is important in order to secure a car loan that won’t add up to become a burden.
Of course, lower interest rates are easier to manage, and finding lower interest rates depends on many factors that are within your reach.
We recommend that you maintain your credit score, make on-time payments, compare all available options and then choose a car loan with the most knowledge at your disposal.
