If you’re planning to buy a new car, you may have considered getting a car loan. A car loan allows you to pay for the car over a fixed number of months instead of paying for your purchase upfront. You’ll need to repay what you borrow, along with interest, to the lender over the loan term.

“When getting a car loan, always look at the total price of the car and the interest rate,” shares Teresa Dodson, debt expert and founder of Greenbacks Consulting. Don't get caught up with the monthly payment,” she urges. The price of the car and interest rate are the most important factors, so you don't overpay for the car,” says Dodson.

But how does interest work on a car loan? In this guide, we explain how interest works, share how it’s calculated, and provide tips on getting a lower interest rate.

How Does Interest Work on a Car Loan?

Car loan interest can be simple or precomputed. With precomputed interest, the interest on the loan is calculated based on the total loan amount at the start of the loan. You’ll pay the same amount of interest each month.

With simple interest, the amount of interest you pay changes each month because it’s calculated based on the outstanding loan balance the day the payment is due.

Principal and Interest Payments

Your car loan payments consist of a portion of the principal and interest on the loan. Auto loans don’t use compound interest, which means that you pay back the loan along with a flat percentage of interest over time.

Most car loans use simple interest, which means that interest is calculated based on the outstanding balance on the loan on the day the payment is due. When you make extra loan payments, the loan balance and interest you owe can decrease.

Another important point to note is that interest is amortized and front-loaded. This means that at the beginning of the repayment term, a larger portion of your car payment will go towards interest. Towards the end of the term, a larger portion of your payment will go to the principal.

For example, if you have a $20,000 car loan at a 4% interest rate and 36-month term, your monthly payment will be $590.48. In the first month, $66.67 of your payment will go to interest. In the last month, you’ll only pay $1.96 in interest, and the remaining will go to the principal.

If your loan has precomputed interest, the interest will be calculated upfront based on the loan amount. In this case, even if you make extra payments or pay off your car loan early, you won’t save as much in interest.

Types of Interest Rates for Car Loans

So, how does interest work on a car loan? To understand this, know the different types of interest rates that come with auto loans.

The interest rate on an auto loan is often listed as an annual percentage rate (APR). An interest rate includes only the interest you’ll pay to the lender for borrowing the money. The APR includes the interest as well as any additional fees you may pay. A loan’s APR will be higher than the interest rate and is a more accurate representation of the total loan cost.

Most auto loans are fixed-rate loans. This means that the interest rate will remain the same throughout the life of the loan. If you prefer predictability, this is perhaps the best choice. With variable-rate loans, the interest rate can fluctuate based on the changes to the prime rate.  

Sometimes, you may come across a 0% APR financing deal. This means that you’ll repay only the amount you borrow to the lender and no interest. While this may seem like the ideal deal, keep in mind that manufacturers may try to make up for it by pushing add-on products like gap insurance or extended warranties.

0% APR deals are usually reserved for those with an excellent credit score for a car loan (800 or above). Review your credit report before shopping around for a car loan to see what you may qualify for.

Average Interest Rate on a Car Loan

What is the average interest on a car loan? A number of factors can impact the interest rates you qualify for, such as your down payment, loan term, and credit score.

The average car loan APR for new cars was 7.03% and 11.35% for used cars in Q3 2023. Note that this is not the interest rate but the APR since that’s what you’ll usually see advertised.

What Factors Affect Car Loan Interest Rates?

Auto loan rates depend on a number of factors. Lenders determine the interest rate you qualify for after reviewing your finances and credit. We’ve listed below some of the main factors that affect the rate you’ll be offered.

Type of Lender

Online lenders, credit unions, and banks offer car loans. Typically, credit unions have lower car loan rates compared to banks. You can also get loans from car manufacturers’ finance companies, and if you have excellent credit, you may qualify for special promotions like 0% APR.

We recommend getting a pre-approval for auto loans from multiple lenders to compare rates and find the best deal.

Credit Score

Borrowers with good credit are more likely to get lower interest rates. While you can get car loans for bad credit, you’ll pay more.

Borrowers with good credit (661 to 780) qualify for an average APR of 6.88% for a new car. In comparison, borrowers with poor credit (501 to 600) qualify for an average APR of 11.86%.

Loan Term 

Loans with longer terms usually come with higher interest rates. You may also end up with an upside-down car loan with a longer loan term because vehicles depreciate quickly.

While a longer term can lower monthly payments, you’ll also pay more in interest over the life of the loan. For example, if you have an auto loan of $20,000 at a 4% interest rate and your term is 36 months, you’ll pay $1,257 in interest over the loan term. If you borrow the same loan for a term of 60 months, you’ll pay $2,100 in interest charges.

Down Payment

Your interest rate may be higher with a smaller down payment. If you default on the car loan, the lender may be left with a car that’s not worth the outstanding amount you owe. This presents a risk to the lender, and they may compensate for it by charging a higher interest rate.

New vs. Used Financing

Car loan interest rates are different for used cars and new cars. New car loans have lower rates because they present a low risk to lenders due to a lower likelihood of expensive repairs and pristine condition.  

Interest Rate Environment

Interest rates change based on market conditions. Loan rates tend to be lower during tougher conditions to encourage more people to borrow money. Interest rates are typically higher when inflation rates are higher.

How To Calculate Car Loan Interest Payments

There are many ways to calculate your monthly car loan interest payments. You can do manual calculations or use an online calculator to make the process easier. For either option, you’ll need some information, such as your interest rate, loan term, and principal amount.

Use a Loan Payment Calculator

There are many free online car loan payment calculators that allow you to determine your interest payments. You can see how your payments change with different repayment terms and loan rates.

You can also reduce the amount of interest you pay by making extra payments towards your car loan. Use a car loan payoff calculator to determine how much extra you’ll need to pay off your loan by a certain date.

Do It Yourself

If you prefer manual calculations, you can follow the process we’ve listed below to calculate your interest payments.

Let’s say you have an outstanding loan balance of $20,000 at a rate of 4%. Here’s how to calculate your next interest payment.

(Interest rate as decimal/12) x outstanding loan balance = monthly interest payment

(0.04/12) x $20,000 = $66.

Tips To Get a Lower Interest Rate on Your Car Loan

Now that you know how interest works on a car loan, it’s important to know that there are ways you can get a lower rate. Here are a few tips to follow:

  • Shop around and compare different auto financing options. Check for special promotional offers you may qualify for.
  • Buy a less expensive vehicle. Don’t take on more car debt than you can afford.
  • Improve your credit score to qualify for a better rate.
  • If the current interest rates are too high, consider postponing your purchase till the market cools down.
  • Opt for a shorter loan term to qualify for a lower interest rate.
  • If you already have a car loan, refinance it at a lower rate when your credit score improves.

How Can I Pay Less Interest on My Car Loan?

There are a few things you can do to minimize the interest you pay. Here are a few options to consider:

  • If you have a good credit score, check to see if you qualify for 0% APR financing, even if it’s for a short period of time.
  • Make extra payments towards the loan to reduce the interest you pay over the life of the loan if you have a simple-interest car loan.
  • Refinance at a lower rate if your financial situation and credit history have improved since you got the loan.
  • If you can afford higher monthly payments, choose a shorter loan term.

Get a Lower Interest Rate on Your Car Loan

Auto loan rates depend on a number of factors, such as your credit score, down payment, loan term, and current interest rate environment. If you’re in the market for a new car, compare loan offers from different lenders and car dealerships to find the best rates.

Use an online auto loan calculator to estimate your monthly payments and how different rates can affect them. Be sure to check your budget to make sure your payments are affordable before borrowing money. Drive off with savings: Master the art of car loan interest and secure lower rates for your next vehicle. Learn the ins and outs, from simple to precomputed interest, and how to score the best deal on your auto loan.