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 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 having 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 your budget allows.
Car Loan Payments
From time to time here at Auto Credit Express, we handle questions from borrowers about their subprime simple-interest car loans, so we thought we'd try to explain your possible interest as simply (pun intended) as possible using a somewhat "typical" loan scenario.
Loan amount: $25,000
Loan Term: 60 months (5 years)
Simple interest annual percentage rate: 15%
Monthly payment: $594.75
With a simple interest car loan you pay the highest amount of interest with the first payment and the lowest amount of interest with the last payment. Here's an example: if you make your first payment on time, you would pay $594.75.
How Does a Simple Interest Loan Work
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.
Since interest is calculated on a daily basis, this is how our example from above would be calculated:
The 0.15 (interest rate) is multiplied by the current balance ($25,000) which would equal $3,750. Divide that by the number of days in a year (typically 365) and you have the daily interest rate ($10.27). Multiply that by the number of days in the month (we'll use 31), and you get that month's interest charges - which in this case would be $318.49.
When you make a payment on a simple interest loan, the money goes towards both interest and principal. This means that $318.49 out of your $594.75 first payment – provided it's made on time – would go towards interest, while the remainder of the payment – $276.26 – would go towards the loan balance which is now $24,723.74.
In the second month, the same interest rate is multiplied by the new balance ($24,723.74) which now equals $3,708.56 – which, when divided by 365, gives us a new daily interest rate of $10.16. Given a 31-day month, provided the payment was made on time, the interest payment would be $314.97, while the principal would be reduced by $279.78 with a new loan balance of $24,443.96.
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. With on-time payments, the pattern of ever-lower interest payments and ever-increasing principal payments continues until the loan is paid off after 58 more payments of $594.75.
Simple Interest Pros and Cons
The beauty of a simple interest loan is that if you decide to work towards paying off your car loan early, the entire additional amount is deducted from the loan balance. This means not only are you reducing the principal amount even more, but you're also reducing the total interest charges on the next month's payment.
For example, if, instead of paying $594.75 the first month you made a payment of $650, the new loan balance following that payment would be $24,668.49 and the interest charge on the next payment would be $314.27. Admittedly this isn't a huge saving at first and could be difficult to do if you're making weekly payments, but over time it will allow you to reduce the principal balance more quickly as well as lower the overall interest paid on the loan.
The downside of simple interest loans, however, is that if payments are made late, the opposite happens. Take our $25,000 loan as an example. If the first month's payment is 31 days late, twice the amount of interest accrues. This means that that $594.75 payment wouldn't even cover the interest charges of $636.74 ($10.27 times 62 days). In this case, none of the principal balance would be paid and there would be an additional $41.99 in interest charges added to the loan plus any late payment charges.
With most simple-interest car loans, the penalties, additional interest charges and any loan balance owed is due at the end of the loan and can result in thousands of dollars in extra costs if monthly payments are consistently late.
How to Save Money on Your Car Loan
Therein lies the beauty of how simple-interest auto loans are structured. They present 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. 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 specify 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 method in which a borrower makes two payments monthly. 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 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 request form.