Simple-interest car loans: What you need to know

Simple-interest loans are one of the most common ways to finance a vehicle, so understanding how they work is a great first step when you're car shopping. Once you know the basics, you'll be able to spot ways to cut your costs and keep more money in your pocket on your next vehicle purchase.

Here's a guide to simple-interest car loans from Capital One Auto Navigator, an online car shopping marketplace.

What Is a Simple-Interest Car Loan?

Simple-interest car loans are loans that are not compounded, meaning that interest is calculated solely off the principal amount borrowed from your lender, rather than the principal plus interest already accumulated. This loan setup is typical for auto loans and short-term financing, and you will even see it used for some mortgages.

Simple Interest vs. Compound Interest

The big difference comes down to how the interest on your loan is calculated. Simple-interest loans charge interest only on the amount you originally borrowed. Compound interest loans charge you interest on the balance and any unpaid interest.

Because simple-interest auto loans stick to a fixed interest rate, your monthly payments stay the same. Compound-interest loans, on the other hand, often use variable rates that can add up fast — costing you hundreds or even thousands more over time, even when you pay on time.

There is another way of handling the interest on a car loan which is called precomputed interest. The total interest is calculated at the beginning and spread over the payments. So making extra payments doesn't reduce the principal or interest in the same way it does with simple interest.

Most auto loans use simple interest. To help you know what type of loan you are considering, refer to the Truth in Lending disclosure, which lists items like the APR, finance charge, amount financed, and total of payments.

How to Calculate Simple-Interest Auto Loans

To find your interest payment, your lender will multiply principal by your daily interest rate, which is usually your interest rate divided by 365 or 360 days — depending on which method is used by your lender.

For example, if you had an auto loan of $20,000 with a 8% interest rate over four years, your estimated monthly payment would be $488.26. Over the period of the auto loan, you would pay a total of $3,436.41 in interest.

However, this calculation becomes more complex when determining your amortization schedule, which shows how your monthly payment is made up of both principal and interest. Your exact amortization schedule will depend on your principal, interest rate, and loan term.

You can use a car payment calculator to help estimate your monthly car payment depending on your loan amount, term length, and estimated APR.  

Simple-Interest Loans Help Reduce Interest Over Time

The main advantage of simple-interest car loans is that borrowers can potentially reduce the total interest over the length of their loan by paying off more of the principal each month, which reduces the interest. In the beginning of your loan's term, much of your monthly payment goes toward interest. Over time, more of your payment goes toward your principal instead of interest.

With a simple-interest loan, your monthly interest is always based on what you still owe on your principal. Consequently, the more principal you pay per month, the less interest will be accrued over time — leading to lower interest overall. Here are a few easy ways to shrink your total interest by making extra payments directly toward your balance:

• Paying more than the minimum payment. Paying off your principal faster reduces the time it takes to pay off your loan, thus reducing your total interest owed.
• Making additional payments. Any additional payments you make toward your principal will reduce your total interest and pay off your principal faster.
• Paying off your principal early. The sooner your principal is paid, the less interest you'll be charged. Check with your lender first to make sure your loan doesn't have a prepayment penalty for paying off the balance early.

Reducing the amount of interest you pay on your auto loan ultimately means paying off your principal as quickly as possible. Since interest is calculated over time, on-time payments and overpayment can be great strategies to save money in the long run.

Late Payments Result in Higher Interest and Potential Fees

While paying early saves you money, late payments do the opposite by adding time to your loan schedule and increasing the overall interest you owe.

Here are a few essentials to keep in mind:

• Added Costs: Lenders often allow a 10- to 15-day grace period but charge a late fee of up to $50 after that.
• Credit Impact: Delinquency can lower your credit score and remain on your report for up to seven years.
• Serious Risks: Missing multiple payments can result in vehicle repossession or legal action.

If you're worried about falling behind, you can contact your lender to discuss deferment or even refinancing your auto loan.

Frequently Asked Questions

What’s the difference between simple and compound interest?

With a simple interest loan, interest is calculated only on your remaining balance. With compound interest, interest is calculated on both your unpaid principal and accumulated interest. Simple-interest auto loans also feature a fixed rate, whereas compound-interest rates can be variable, often making compound loans more expensive over time.

How is simple interest calculated on a car loan?

Your lender multiplies your remaining principal balance by your daily interest rate, which is your annual interest rate divided by either 365 or 360 days (depending on the lender's policy).

An amortization schedule then determines how each monthly payment is split between covering that accrued daily interest and paying down your principal balance.

Daily Interest=Principal Balance × (365 or 360 Annual Interest Rate )

Do all car loans use simple interest?

While simple interest is one of the most common structures for auto loans, not every car loan uses it. Contract terms vary by lender, so it is important to review your specific loan agreement to confirm whether your interest is calculated on a non-compounded simple-interest basis.

What happens if I make a late payment on a simple-interest loan?

Paying late stretches out your loan schedule, causing more interest to accumulate over time and increasing the total cost of your loan. Additionally, lenders may charge a late fee (often up to $50) after a 10- to 15-day grace period. Late payments can harm your credit score for up to seven years or lead to having your vehicle repossessed.

Can I pay off a simple-interest car loan early?

Yes, paying off your principal early, or making additional and larger monthly payments, reduces the remaining balance that interest is calculated against, saving you money overall. However, you should check with your lender to see if your contract includes a prepayment penalty, which can apply depending on your specific loan terms.

This story was produced by Capital One Auto Navigator and reviewed and distributed by Stacker.