With car financing, car buyers receive a lump sum of money from a lender and then make monthly car payments until the vehicle loan balance is repaid. Unlike unsecured credit cards, personal loans, and student loans, auto financing represents a type of secured loan.

Here, a bank, credit union, or other lender retains ownership of the car financed as collateral (security) during the loan term until all loan payments are completed. If a borrower defaults on the auto loan repayment agreement, the lender can repossess the car.

Interest charges are separate fees paid in addition to the loan principal balance. Car loan interest is essentially the finance charge that compensates the lender for the cost of borrowing that is typically expressed as a fixed rate percentage.

How Is Interest Calculated on a Car Loan?

There are simple interest loans and compound interest loans. Simple interest payments are calculated based on the principal amount borrowed. Compound interest is calculated based on the principal and adds previously accrued interest.

Simple interest usually applies in the financing of car loans, installment loans, and sometimes in mortgage loans. Compound interest translates to an increasing amount of interest throughout the loan term, as the debt remains outstanding.

Compound interest is generally inapplicable to the car loan market. 

Monthly Simple Car Loan Interest Rate Example

Payment	Principal	Interest	Total Interest	Balance
$ 300	$ 258	$ 42	$ 42	$10,000
$ 300	$ 259	$ 41	$ 82	$ 9,742
$ 300	$ 260	$ 40	$ 122	$ 9,483
$ 300	$ 261	$ 38	$ 160	$ 9,223

Source: Auto Loan Interest

Simple Interest Car Loans

Car loan interest rates today are usually calculated using simple interest. Each monthly payment made has money allocated for the principal and the interest.

During the early phase of a car loan, a more substantial portion of the money from each monthly payment is directed toward interest. However, this pattern begins to shift as the loan balance declines with each monthly payment.

The term used to describe how initial payments are directed toward interest but decline over the longer loan term is referred to as amortization.

Simple interest loans are largely preferred over competing models for various reasons. For example, the borrower enjoys predictable monthly payments and has the option of making larger payments toward the principal to reduce interest charges and pay the loan off sooner.

Keep in mind that failing to make a payment on the due date will result in late fee penalties and may be noted in your credit history and adversely impact your credit rating.

Car Loan Interest Rate Formula

Simple Interest = P × I × N

P = Principle

I = Daily Interest Rate

N = Number of Days Between Payments

Precomputed Interest Car Loans

Although they are much less common, it is worth gaining an understanding of precomputed interest loans in case you encounter one. Unlike simple interest loans where interest is calculated as you pay the balance, precomputed loans have the interest calculated upfront.

In a precomputed loan, lenders make a calculation of how much interest the borrower will pay over the entire loan term assuming they make the minimum payment each month.  Here, the borrower pays the same amount of interest regardless of whether they pay off the loan early.  

Precomputed interest loans are generally seen in the personal loan market and in auto loans by lenders that extend financing to those with poor credit, also referred to as subprime borrowers.

Precomputed loans have traditionally been viewed controversially, in part because the law generally prohibits lenders from charging interest that has not yet accrued. Lenders rely on the “Rule of 78” to ensure they retain their profit from the interest on each loan.

In 1992, the U.S. government imposed a restriction that prohibits lenders from using the Rule of 78 on any loans that have a term of longer than 61 months.

Difference Between an Interest Rate and an APR

Sometimes the term’s annual percentage rate (APR) and interest rate are mistakenly used interchangeably when discussing loans. Both terms do refer to the cost of borrowing (using credit), but they are different.

The interest rate is the yearly cost the borrower pays expressed as a percentage. The APR does include the interest rate; however, it also encompasses all the fees that are associated with the loan, which makes it a larger number.

Put another way, the APR is an expression of the “true” or actual cost of obtaining credit, and consumers that are comparing competing credit options should always use the APR.

Some examples of fees that might apply include registration fees, extended vehicle warranty coverage, and documentation fees.  Aside from car loans, APRs are also common variables used in the realm of mortgage loans.  

Factors That Affect the Interest Rate on Your Car Loan:

Why is obtaining a good interest rate important when financing a vehicle today? One primary reason is that the average new car today has a $40,000 price tag, meaning that you are potentially borrowing and paying interest on a significant amount of money.

While new car prices rose by roughly 5% this year, used car prices spiked by approximately 27%.

Your Credit Score

What is a good credit score to buy a car?  There is no current minimum credit score standard or threshold requirement to finance or refinance a car; however, your ability to qualify for lower interest rates is heavily dependent on your credit.

Those with a credit score in the range of 500 will have limited financing options and should expect to pay outrageously high-interest rates. Generally, a score of 740+ is very good and those with an 800+ score have virtually limitless financing options.

Can you lease a car with bad credit? Leasing a car is roughly equivalent to a long-term rental for a defined number of months. Recent data shows that 83% of leases involve motorists with a credit score of 661 or more. 

The majority of leases are for new vehicles and most dealers require at least an average credit score.

In many cases, prospective car buyers are encouraged to take some positive steps to improve their credit score instead of paying the excessive interest rates of a subprime car loan. One such tool for boosting your score is a credit builder loan.

Subprime borrowers might consider a credit builder loan from Credit Strong. The organization is a five-star rated and FDIC-insured part of Austin Capital Bank.

Credit Strong’s credit builder loans have the loan funds deposited and secured in a savings account. The borrower then begins making affordable, fixed monthly payments toward the loan balance, which are promptly and regularly reported to the three credit bureaus.

After the balance has been paid in full, the funds in the savings account are released to the borrower and a consistent credit history that results from the installment loan has been established.

Your Loan Term

The majority of original and refinanced auto loans range from 36 to 72 months. In general, shorter-term loans will have lower interest rates, as 36-month term loans average 3.86% and 72-month loans average 4.15%. 

Consumers should avoid fixating solely on monthly payments and consider the overall (total) cost and value. This involves finding a balance between the affordability of the monthly payment and the amount of extra interest you will pay over the longer term.

In recent years, more borrowers are entering longer-term loans that stretch from 72 to 84 months. Roughly 33% of new car loans today have terms ranging from 73 to 84 months.

To compare overall costs including interest consider this example: 

• $25,000 vehicle @ 4% for 48 months = A monthly payment of $564 and total cost of $27,100
• $25,000 vehicle @ 4% for 84 months = A monthly payment of $342 and total cost of $28,270

Your Down Payment

Making a substantial down payment toward the purchase of a financed vehicle is typically wise—especially for subprime borrowers.  A 20% down payment is a loosely recognized standard, but extending this to 25% often has significant financial advantages.

Borrowers equipped with a solid down payment may benefit from having lower monthly payments, qualifying for more loan options with reduced interest rates, and are better positioned to avoid reaching a negative equity position stemming from depreciation.

In many cases, lenders will impose a down payment requirement as a qualifier for a loan or for loans with more favorable rates. Remember that lenders generally increase interest rates as a means of offsetting the greater risk of financing borrowers with bad credit.

Many financial institutions establish lending guidelines that include specific loan-to-value ratio (LTV) requirements. The formula for LTV is: 

LTV % = Total Dollar Value (Amount of Loan) / Actual Cash Value (Car’s Market Value)

For example, if ABC Bank requires a 90% LTV, a borrower must have a minimum of a $1,000 down payment to finance a $10,000 vehicle.

Cars continually lose value (depreciate), which poses risks associated with negative equity. This is when a borrower owes a balance to a lender that exceeds the vehicle’s value, which is sometimes explained as being “underwater” or “upside-down”

Type of Lender

Car loan interest rates may vary based on the category or type of lending institution. We will discuss some general data and trends; however, avoid making assumptions and always do some comparison shopping, as lenders have their own variable rates and guidelines.

Large banks are a major source of car loans and offer competitive rates, but often lend only to borrowers with average, good, or excellent credit. Local or regional banks might be more flexible, particularly with applicants that have existing banking relationships.

Credit unions often have excellent interest rates and are more willing to work with borrowers that have below-average credit. Keep in mind that credit unions typically loan exclusively to members, which might be reserved for those in certain geographic locations, professions, etc.

Auto dealers usually have relationships with various lenders and are often motivated to shop around on your behalf to sell a car. Deep subprime borrowers might be limited to buy-here-pay-here dealers that provide loans with very high-interest rates and fees. 

New or Used Car

Car loan interest rates may vary based on whether the vehicle is new or pre-owned. As the chart below indicates, new car loans tend to have lower overall interest rates.

Although a high-end or luxury used vehicle might be priced similarly to a subcompact or economy-class new vehicle, used cars tend to be priced lower.  Keep in mind that individuals buying new cars generally have better credit scores and qualify for better rates.

New vehicle manufacturers sometimes offer special captive financing incentives through their dealership networks to sell more new vehicles i.e., 0% financing offers from Toyota Financial Services, Ford Credit, and Hyundai Motor Finance.

Overall average interest rates for used cars are somewhat inflated because the subprime market includes the buy-here-pay-here dealers that charge exorbitant interest rates and generally offer exclusively used vehicles. 

In some cases, lenders may increase used car rates to account for the added risk. For example, used cars have less value making them more likely to be a “total loss” in serious accidents, which data suggest increases the likelihood that the lender will lose money.

A consumer should shop for an auto loan from different lenders, regardless of if the vehicle is new or pre-owned.

New vs Used Vehicle Interest Rates

Credit Score Category	Credit Score Range	Average APR: New Vehicle	Average APR: Used Vehicle
Super Prime Borrower	781 – 850	5.25%	7.13%
Prime Borrower	661 – 780	6.87%	9.36%
Non-Prime Borrower	601 – 660	9.83%	13.92%
Subprime Borrower	501 – 600	13.18%	18.86%
Deep Subprime Borrower	300 – 500	15.77%	21.55%

Source: Experian 2024

Things to Know About Auto Loans:

Auto Loan Pre-Approval

Consider obtaining a loan pre-approval from a bank, credit union, or online lender before visiting a dealer. Pre-approval affords you the benefit of knowing your pricing limitations for a car, insight into the current interest rates, and may provide leverage in price negotiations.

With a pre-approval in hand, you might consider asking the dealership to shop around in their lender network to identify any options that will offer you a better rate. 

Auto Loans are Amortized

Similar to most mortgage loans, auto loans amortize over the term of the loan. At the beginning of the loan, each monthly payment is applied proportionally between the loan’s principal and interest, with a larger percentage allocated to interest.

With each monthly payment, a greater portion increasingly is allocated to the principal, and less goes toward interest.  

Prospective car buyers should recognize how establishing and improving your credit can save you considerable amounts of money compared to paying car loans with exorbitant interest rates.

CreditStrong helps improve your credit and can positively impact the factors that determine 90% of your FICO score.

Start Building credit today