This is a great question and one you will want to understand. Simple Interest Auto Loans are closed end
loans, also known as Installment Loans. This means that you cannot add any additional
money to the current loan. This is the opposite of Credit Cards which are Revolving Loans
and although the interest is calculated the same, the user can add funds to their existing account, which changes
the amount to finance each time the user purchases an item.
A Simple Interest Loan is ideal and gives you the ability to make additional payments, which will reduce your balance
as well as your total interest charges. This also gives you the opportunity to pay your loan off earlier than the
contracted length. The interest you pay per month is based off your balance, so the lower your principal, the less
interest will be charged to your payment. Keep in mind that although paying additional money towards the balance can
lower your interest, your monthly payment will not change.
| How much of my payment is interest? |
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The amount of interest per payment will change every month based on your balance. To calculate the exact amount of
interest per payment, we will give you an example of a loan and demonstrate how the payment stays the same, however
the ratio of principal v/s balances changes. For the following example, we will use a loan with an amount to
finance of $15,000, an interest rate of 7.5%, and a term of 48 months, with a monthly payment of $362.68. (Note:
The $15,000 is not the sales price of the car, it is the amount to finance after taxes, fees, and down payments.) |
The formula to figure out how much of your payment goes to interest is as follows:
(Balance * Rate) / 12 = Interest applied to payment.
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So for your first payment, we would use the following calculation to figure how much of your monthly payment is going towards interest:
($15,000 * 7.5%) / 12 = $93.75
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This would be the amount of money applied to the principal balance from your first payment:
$362.68 - $93.75 = $268.93
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From the examples above, we can see that your first payment will have $268.93 applied to your principal balance
and $93.75 charged as interest. Since each month the interest is recalculated based off your balance, lets see
how much of your payment will be interest for the following month. We will take the amount to finance $15,000
and subtract the amount of principal applied, so in this case, it would be:
Here is how you can figure out the following months interest charges: |
$15,000 - $268.93 = $14,731.07.
*Note that you do not subtract the actual monthly payment since $93.75 was charged as interest. |
So for your second payment, we would use the following calculation to figure how much of your monthly payment is going towards interest:
($14,731.07 * 7.5%) / 12 = $92.07
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This would be the amount of money applied to the principal balance from your next payment:
$362.68 - $92.07 = $270.61
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How to figure out the interest charges after 1 years worth of payments:
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Now lets see how much 1 years worth of payments affects the figures. For the following example, we are using
a balance of $11,659.52. (This would be your balance after 1 year assuming you made no additional payments towards the principal balance.)
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($11,659.52 * 7.5%) / 12 = $72.87
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This would be the amount of money applied to the principal balance:$362.68 - $72.87 = $289.81
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These examples show the lower your principal balance is, the less money that will be charged as interest.
This is why it’s important to pay as much money as possible towards your balance so you will save money.
This formula works regardless of term length because the longer the term, the less money applied to the balance,
which significantly increases the amount of interest charges.
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Why and When to Refinance your car loan
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Refinancing is actually taking out a new loan to pay off your current car loan and close the old account. There are
different reasons people will refinance a car loan. The three main reasons are to remove a name (co-signer)
from the loan, pull possible equity from the loan, or most common, to lower the current monthly payment. Here is
a brief explination of each instance.
If you needed someone to co-sign for you when you purchased the car, you may want to
refinance the vehicle to put the loan in solely your name. The other side would be if you co-signed
for someone and you want your name removed; this would be the process you would want to
follow to successfully remove your name and obligation from the loan. Both parties would need to
close the current loan before a new loan may be opened for the car. The new lender will pay off
the current loan and open the new one without the co-signer, assuming the person qualifies for the loan.
If the retail loan value of your current vehicle is higher than your balance, you can take out a
new loan for the higher amount and receive the difference in cash. The drawback to this method is
your monthly payment will typically increase, unless you can lengthen your term, and you will pay
more money in interest since your principal balance will be greater. This is typically not an efficient
method of acquiring money, however it is possible in some cases.
If you have 3 years left to pay a car loan with a payment of $388 per month and a balance of
$12,000, you might take out a new loan for the $12,000. However spread the balance over a 48-
month term, then depending on the interest rate, you can lower your payment to $310 per month.
The disadvantage to this method is you now have 4 years to pay on the vehicle instead of 3, which
also means you will pay more money in interest over the term of the loan. Your second loan will
sometimes have a higher interest rate than the first one, so before you refinance, make sure you
understand the additional interest you will pay in relation to the lesser monthly obligation.
