Simple Interest Explained

Simple interest can be great as long as you make your payments on time

Car Loan Payments

Simple Interest Explained

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: $15,000
Loan Term: 60 months (5 years)
Simple interest annual percentage rate: 17 percent
Monthly payment: $372.79

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 $372.79.

How Simple Interest Is Calculated

Interest is calculated on a daily basis, so for our example here is how it would be calculated:

The 0.17 (interest rate) is multiplied by the current balance ($15,000) which would equal $2550. Divide that by the number of days in a year (typically 365) and you have the daily interest rate ($6.99). 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 $216.69.

This means that $216.69 out of your $372.79 first payment – provided it’s made on time – would go towards interest, while the remainder of the payment – $156.10 would go towards the loan balance which is now $14,843.90.

The second month the same interest rate is multiplied by the new balance ($14,843.90) which now equals $2523.46 – which, when divided by 365, gives us a new daily interest rate of $6.91. Given a 31 day month, this means that provided the payment was made on time, the interest payment would be $214.21, while the principal would be reduced by $158.58 with a new loan balance of $14,685.32.

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 $372.79.

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, you’re also reducing the total interest charges on the next month’s payment.

For example, if, instead of paying $372.79 the first month you made a payment of $400, the new loan balance following that payment would be $14,816.69 and the interest charge on the next payment would be $213.90. Admittedly this isn’t a huge savings at first, and could be difficult to do if you’re making weekly payments, but over time it will allow you to reduce the principle 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 $15,000 loan as an example. If the first month’s payment is 31 days late, twice the amount of interest accrues. This means that of that $372.79 payment wouldn’t even cover the interest charges of $428.42 ($6.91 times 62 days). In this case, none of the principle balance would be paid and there would be an additional $55.63 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 charges if monthly payments are consistently late.

The Bottom Line

There are a number of advantages to simple interest loans, not the least of which is the ability to pay one off sooner and reduce the interest charges without any penalty. The downside, however, is that additional interest charges and penalties can add up quickly if payments aren’t made on time – especially during the early stages of the loan.

Posted on December 10, 2014 by in Auto Loans
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