How a Simple Interest Car Loan Works

In simple terms, a car loan is a way to borrow money from a bank or other financial institution so you can buy the car you’ve been eyeing. You make monthly payments toward the price of your new or used vehicle, and in between those payments, you have possession of the car itself.

Each time you pay toward your auto loan, the interest you’ve accumulated begins to shrink. The amount of money you borrow dwindles as you pay back the loan until, eventually, your balance equals what you initially borrowed minus the total you have paid back.

So why not just pay off your car loan early? You could if it were a simple interest loan. Unfortunately, most car loans are “amortized,” which means you have to keep them for the full loan term.

How a simple interest car loan works

Many financial institutions offer simple interest car loans but compare auto loan rates before signing on the dotted line.

Many people compare car loan quotes with simple interest only to find out it’s more expensive in the long run. If your credit history looks good, compare car loan rates with a fixed interest car loan, or else your overall payment will increase.

A simple interest loan requires that the lender uses the balance of the loan at closing, plus accrued unpaid interest, as the basis for determining the note’s monthly payment amount.

With a fixed interest loan, the lender calculates your monthly payment by adding together the loan amount, accrued unpaid interest, and any fees applied to the note. The sum of these is divided by your total number of months in the loan term.

Here’s an example showing you how a simple interest car loan works: You take out a simple interest car loan for $15,000 at 16% APR. You borrow the car’s entire balance at closing, and this amount remains on your credit report for three years as the total debt owed.

Simple interest auto loans are sometimes referred to as debt totals because the monthly payments are based upon the dollar amount of your debt, not what you owe after any payments are made.

Your note is for 36 months, meaning your car loan term is three years. To determine your monthly payment amount, the lender would take $15,000 and multiply that by .16 (16% simple interest rate) to arrive at a monthly finance charge of $250. The sum of these two figures equals your monthly statement balance.

In the above example, after paying $250, if you have a simple interest car loan with no additional fees, you will still owe $14,750 on your note. However, compare auto loan rates with fixed interest loans that require lower monthly payments because the note’s balance decreases as you pay down the principal amount.

For example, compare auto loan rates for a 36-month term of $15,000 at an APR of 8% with a corresponding payment of $350. After making that first month’s payment, you will have reduced your balance to only $14,650.

According to Lantern by SoFi, “Compare rates for a fixed interest car loan to save money, especially if you have good credit.”

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