A majority of lenders use simple interest contracts for car loans. Simple interest auto loans are those where the interest is computed on a daily basis. It sounds daunting when you think about interest accruing every day, but simple interest auto loans are actually structured in a way that presents the consumer with opportunities to save money.
How Long Should My Car Loan Be?
When determining what kind of car payment you can afford, it is important to recognize that there is a bigger picture to focus on. While a longer loan term will come with lower monthly payments, it will also result in a higher interest charges.
For buyers with bad credit, it is especially important they think in terms of total cost, rather than monthly payment. Since these borrowers are viewed as a greater lending risk, they'll probably be faced with an APR that's higher than average.
While it is important to budget for a monthly car payment, extending the term can greatly increase the overall cost of the loan. Therefore, the first step in saving money should be to shorten the loan term as much as the budget allows.
Making Sense of Simple Interest Auto Loans
When taking out a car loan, the contract specifies the interest rate, the loan term and the monthly payment. If the loan is a simple interest contract (and most are), borrowers can take advantage of how they work to reduce the total interest expense.
With a simple interest auto loan, interest accrues on a daily basis based on the outstanding balance (principal balance). Basically, the higher the principal balance, the more interest will accrue. So, the amount of interest that accrues will be highest at the beginning of the loan when the outstanding balance is highest.
When you make a payment on a simple interest loan, the money goes towards both interest and principal. For example, if the monthly payment is $300 and $140 worth of interest has accrued since your last payment, $140 of the payment covers the interest charges and the remaining $160 is deducted from the principal balance.
So, each and every payment that the borrower makes will lower their principal balance, which in turn will lower the amount of interest that accrues with the next installment. Essentially, simple interest loan borrowers end up paying less and less in interest with every payment, which allows more of the monthly payment to be applied to the principal. This pattern of decreasing interest payments and ever-increasing principal payments will continue until the loan is paid off.
How to Save Money on Your Car Loan
Therein lies the beauty of how simple interest auto loans are structured. It presents the savvy consumer with opportunities to save money on interest expenses over the course of a loan.
- Taking Advantage of a Lack of Pre-Payment Penalties
Simple interest auto loans rarely, if ever, come with pre-payment penalties, so borrowers are not hit with a fee if they are able to pay it off early. So if your financial situation allows you to be able to pay more than the monthly payment amount, you can save yourself money in the long run. If you so designate it, any additional amount you add to your payment can be deducted from the balance owed, and we know what that means. It will reduce the principal balance even more, which will further reduce the total interest charges on all future payments. It's truly a win-win scenario and the quicker you pay off the loan, the less in interest charges you end up paying.
- Payment Splitting
Another tactic that can help you save money on a simple interest auto loan is a method known as "payment splitting." Because interest accrues on a daily basis, the sooner a payment is made, the lower the interest charges that accrue thereafter will be. Payment splitting is a technique in which a borrower makes two separate payments each month. And no, we aren't talking about doubling the payment amount. Instead, let's say there's a $300 payment due on the 20th of each month. Using the payment splitting technique, the borrower would pay $150 of that earlier in the month (let's say the 5th to keep things even), and another $150 on the actual due date. This allows for a slight reduction in the daily interest charges that accumulate between the two payments. If done over time, payment splitting can make a big difference in the amount of interest a borrower ends up paying.
Borrowers should also recognize that being late with their payments will not only damage their credit, but also increase the interest charges. Because interest is calculated daily, the later the payment, the more interest that will accrue based on the loan's daily balance. This means that borrowers should do all they can to make sure that their payments are never late.
The Bottom Line
A borrower can take advantage of the way simple interest auto loans are structured and save money over the course of that loan. This can be accomplished by reducing the loan term, paying more than the monthly amount, and payment splitting. Make sure to inquire about simple interest contracts with no pre-payment penalties before signing any loan-related paperwork.
Even consumers with less than perfect credit can use these tactics to their advantage when taking out an auto loan. But first they need to get approved, which can be more difficult when you have poor credit.
Luckily, Auto Credit Express is here to help. Our service connects credit-challenged consumers to the dealership in their area that stands to give them their best shot of being approved for an auto loan. The best part is that applying is free and the service is fast. We can help you next if you simply complete the secure and obligation-free online application.