What Interest Rates Mean For Car Loans

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It may seem like a good idea to get an auto loan with a longer term and lower interest rates to keep your monthly bill below a budget-stretching level, but is it the right choice for you?

This question is best answered by understanding how Car finance work.

Here are three important things to know about car finance.

New car prices are up 12.1% from a year ago to $45,031 as of September 2021, which leads to longer-term auto loans1 for consumers. The average auto loan term is now at 72 months as of Q3 2020.

To help you decide whether to take out an auto loan, here are three things to consider:

  • The interest rate on auto loans changes every day, and it varies widely.Be sure to check current auto loan rates before visiting a dealership. Before shopping for a car, it might be wise to get pre-approval from a bank or credit union. The consumer advocates say that you may get a good car deal, but not a good deal on the financing. It is important to know what a “good deal” is on a loan at the moment.
  • Simple interest is charged on auto loans, not compound interest.This is a good thing. In return for the money, the borrower must repay a flat percentage of the amount borrowed. Compound interest snowballs the amount paid over time since the interest earns interest over time.
  • With an auto loan, the interest is front-loaded, as with a mortgage.When housing prices collapsed, those who owed more than their homes were worth for resale were said to be “underwater.” Likewise, car buyers can be driving “underwater” for a long time unless they had a substantial down payment or a late-model trade-in, as cars depreciate rapidly as soon as you drive them off the lot.

Numbers crunched

These examples illustrate how a car loan determines the real cost of a car. It is the same price regardless of whether the car is used, whether the down payment is made or whether there is a loan: $45,031. Down payments are 10%. Financing will be $40,529.

The monthly payment for a 4% loan will be $746.38 over five years. Your total payments would have been $44,783.09 at the end of that period.

If you stretched that loan to eight years, the monthly payment would drop to $494.01. At the end of that time, your loan payments would total $47,424.67.

How Much You Pay Each Month – and the Total

It is crucial that you get a good interest rate on your loan. If you had to pay a 6% rate instead of a 4% rate for the same car, the numbers would be drastically different.

  • If you were to borrow $40,528 for five years at 6% interest, your monthly payment would be $782.52. Your annual payment would be $48,011.19. Including the 10% down payment, the car would cost $51,514.19.
  • The monthly payment on that $40,528 loan at 6% interest drops to $532.60 if it were extended to an 8-year term. A total of $51,129.20 would be due on the loan. The car costs $51,661.80 if you include the 10% down payment.

Use the Investopedia Auto Loan Calculator to run the numbers yourself.


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