How Does Interest on a Car Loan Work?
Posted by Frank Gogol
If you are considering to borrow money to buy a car, it is a good idea to understand exactly how car loans work — whether you’re an international student or otherwise. More importantly, you need to know how does interest on a car loan work. You need to ask these important questions:
- What is the interest you will be charged?
- How is it calculated?
- What is the repayment term?
- How much will you actually be paying back in the end?
These are all important factors you should take into account. It is also important to consider these factors in light of your monthly budget, especially if you are not a U.S citizen or permanent resident. Below we explain how car loans work.
Table of Contents
How Do Car Loans Work?
A car loan is a lump sum of money you receive from a lender that enables you to buy a car.
The long and the short of how a car loan works are as follows:
- You need to work out how much money you will need to buy a car (especially if you want to buy a specific car).
- Approach a lender to borrow that specific amount.
- The lender will review your documents and information and decide if they are willing to lend you all, some or none of the money.
- If you are approved, the lender will offer you a loan amount and an interest rate.
- If this is acceptable to you, you agree to the terms and conditions and repayment schedule of the loan.
- Once you have agreed to the terms and conditions, you will receive your loan amount.
- You will have to make repayments every month. These repayments reduce your outstanding amount (i.e. the amount you still owe on the loan). Your repayment amounts consist of interest repayments as well as repayment on the initial loan amount.
The process explained above will apply to everyone who applies for a car loan, irrespective of whether you are a visa holder, citizen or permanent resident.
An easy way to think of a loan is like this: Your lender buys your car for you and allows you to pay it back over a period of time. The interest you are charged is payment to the lender for the service of using their money.
Principal, Interest, and Repayment Terms
The essential components of a loan are the principal, the interest, and the repayment terms. Here is what each of these mean.
What is Principal?
Principal is the total lump sum of money that you borrow from the lender. This is usually the same amount as the price of the car you are buying.
What is Interest?
Interest rate is the “fee” a lender asks in return for you lending its money. The interest rate is applied to your outstanding balance or principal amount.
The interest amount is the actual amount of interest that you pay per repayment. So essentially the portion of your repayment that is interest and not repayment of the actual loan amount.
What are Repayment Terms?
Your repayment terms are the arrangements surrounding your repayment of the loan. This essentially consists out of the repayment schedule and repayment amount. The repayment amount is the amount that you are required to repay every month. The repayment schedule is the period over which you repay your loan.
How Interest works for Car Loans
So how does interest on a car loan work?
Understanding fixed rate on your car
Most car loans offer a fixed interest rate. This means that the interest rate charged on the loan does not vary over the loan term. Car loans are also usually referred to as “simple” loans. This refers to the fact that the interest applicable to car loans is simple interest and not compounded interest. This means that the interest is only calculated on the principal amount (i.e. the outstanding loan amount) and not on the accumulated interest as well. This definitely saves you money in the long run!
With most car loans, the interest is calculated and applied to the outstanding balance on a daily basis.
Two big factors that determine how much interest you pay
It is important to remember that it is not only your interest rate that will determine how much interest you pay on your loan. Your loan term will also influence this. The longer your loan term, the more interest you will pay. High interest rates and long repayment schedules will keep you from getting out of car debt for a long time!
Reducing your interest
Many people also wonder how to reduce their interest charges. Your interest charges every month is based on how much of your loan is still outstanding, so one way to reduce your interest is to make unscheduled payments to bring down your loan balance. Although it is probably a wise financial decision make sure to take your entire financial situation into account before making unscheduled payments. There might be better places to spend the extra cash than paying it into your car loan (like rather paying off your credit card which has a higher interest rate).
Another option to reduce your interest charges might be to refinance your car. In short refinancing, your car means that you take out a new loan which has lower interest rates to repay your existing car loan. You will still have the same amount of outstanding debt, but as your new loan has a lower interest rate, you will be paying lower interest charges. You can learn more about refinancing your car here.
If you are wondering how much interest you will pay over your loan term, there are many loan calculators available that will help you calculate this information. You can find a loan repayment calculator on this page over here. You can even try out this auto refinance calculator.
What is APR?
Interest is not the only cost to loans. Other fees might apply to the car loan you take out. These fees can include origination fees, transaction fees etc. It can be quite difficult to understand and compare the actual cost of different loans, so these additional fees applicable to loans are translated into an APR (Annual Percentage Rate).
APR is also expressed as a percentage but this percentage takes into account the interest rate and additional fees payable on the loan. APR is essentially the annual rate of finance charge you pay on your loan and would be your interest rate if there were no additional costs or fees involved.
When comparing loans, you have to compare APR’s and not just interest rates. Some lenders can catch you with a low interest rate because there are more months attached to the schedule and also very high costs and additional fees. These costs will be reflected in a higher APR and showing all interest rates an APR gives borrowers a way of comparing their options.
Financing A Car: What Are the Options
If you are not able to get a traditional auto loan there are other options you can consider to finance your car. The two most common ones are to finance your car with a credit card or a personal loan.
Financing with a Credit Card
Many people consider financing their car with a credit card. This means that you get a credit card with a big credit limit (or increase your existing credit card limit) and pay for your car with your card. As we explain below, this is not a good idea and definitely not a wise financial decision. You should rather consider your other loan options before opting to use your credit card to finance your car.
Financing with a Personal Loan
Using a personal loan to buy a car will definitely be a better idea than using your credit card. If you have a good credit score, this will probably be one of your cheaper options.
You can either take out a secured personal loan (which means you provide an asset as collateral) or an unsecured loan. If you are confident about your ability to repay your loan, you can consider taking out a secured personal loan as this will get you a better interest rate. Keep in mind the risk that, if you default on your loan payment, you might lose your asset.
Although personal loans are one of your cheaper options, the interest rate will probably be a little bit higher than traditional auto loans. If this is your only option (other than a credit card) this is definitely the way to go.
3 Reasons Why Financing Your Car with a Credit Card is a Bad Idea
Buying a car with your credit card will never be a good idea. Here’s why.
1. Interest Rates Fluctuations
The interest rate on your credit card fluctuates. This means that your interest rate could go up somewhere during your repayment period and essentially your repayments will increase as well. This does not provide any certainty regarding the actual cost of your loan or your monthly repayments. You might even end up with credit that you can’t afford.
2. Minimum Payments
Credit cards offer low minimum payments. If you only pay the minimum payment amount it will take you much longer to pay off this debt than making the normal car loan repayment amounts. The longer you take to pay off debt, the more interest accrues and the higher the cost of your debt.
3. Interest Rates Amounts
Interest rates charged on credit cards are a lot higher than those on normal car loans. This means the cost of your credit with a credit card will be higher.
How Much Will Borrowing on a Credit Card Cost?
On average, credit card interest rates are around 16%. For an auto loan, you can work with about 6%.
How much will this extra 10% interest cost you in the long run?
If you get a loan of $10 000 and you repay it over a period of three years your interest repaid will be $952 for an auto loan and $2 657 for the credit card. So you’ll end up paying $1 705 more interest with a credit card than an auto loan.
If you take out a loan of $20 000 and repay it over a period of five years your interest paid for the auto loan will be $3 199 and $9 182 for the credit card. You end up paying $5 983 more for the credit card.
Considerations Lenders Take into Account when Deciding to Give Loans
Lenders take a variety of factors into account when deciding whether to grant a loan and which interest rates and repayment terms will apply to a loan. These factors might differ from lender to lender, but generally, the following factors will be taken into account.
Your credit history will always be important for any lender. Your credit history shows the lender whether you honor your payment obligations and will give them an indication of whether you will make your scheduled repayments.
If you are not a U.S citizen or foreign national, this might cause some difficulty for you as many lenders only consider your U.S credit history. Fortunately, there are lenders like Stilt who will take other factors and your credit history from your home country into account as well.
Your credit score is also a reflection of your credit history. Your credit score serves as an indication to a lender of the level of risk you are.
Amount being borrowed
Your credit history will show the lender how much you have borrowed in the past and also how much current outstanding debt you have. If you have only had small loan amounts in the past, this does not create confidence in the lender that you will necessarily be able to pay off a big loan amount. Similarly, if you currently have a lot of outstanding debt, the lender won’t regard you as having the capacity to pay off more big loan amounts. So the lender will take into account the amount you want to borrow, and compare it with your credit history and your current outstanding debts. If the loan amount you want is big, there is a bigger chance that your application will be denied or that you will only be granted a smaller amount.
This is important to a lender as they will want to know whether you can actually afford the loan they give you. If your monthly income is not enough to cover your monthly repayment with your normal monthly expenses, the lender won’t grant you a loan.
Car Loans for International Students
Getting an auto loan if you are an international student can be hard. You might not be able to provide a Social Security Number (SSN), U.S credit history or credit score as an international student, which means that you won’t be able to get a loan from many of the traditional lenders. Some traditional lenders might offer you a car loan as an international student, but the interest rate charged for the risk they take could be extreme.
There are many non-traditional lenders that will offer international students in the U.S car loans. Some lenders will provide you with a personal loan to buy your car, or will offer you an actual auto loan.
These lenders consider factors like your educational or financial history in your home country into account and might even consider your foreign credit score. They will also look at your earning potential in the U.S or allow a cosigner as extra security to them. All of these factors mean that you will not only be able to get a loan to get a car in the U.S but you might even get a relatively competitive interest rate.
5 Factors Considered in Auto Loans for International Students
If you are an international student looking to take out an auto loan, the following factors will be taken into account by lenders.
No Credit History
Not having a credit history is usually red lights to a lender. This is a real factor for international students as you probably haven’t been in the U.S long enough to build a credit history. Some lenders take your credit history from your home country into account which helps.
No Social Security Number
Your Social Security Number (SSN) is given to everyone who works in the U.S. The function of an SSN is to track your income for tax purposes. This document is usually a bonus for lenders, as it not only means that you earn an income but that they can see exactly how much you earn.
Although this is a bonus to lenders, it won’t be a deal breaker for all lenders if you don’t have an SSN. There are lenders that will give an auto loan to international students without an SSN.
No Permanent Resident Status
If you are not a permanent resident or citizen (i.e. you are just a visa holder), you’ll be able to avoid paying your loan if you head back to your home country. The lender’s ability to enforce repayment of the loan if you are not in the U.S will be limited. So not being a permanent resident essentially means you are a higher risk.
Your earnings potential will give the lender an idea of whether you are able to afford the loan you are applying for, even if you don’t necessarily have a financial history in the U.S. If you have a good earnings potential, it means that the chances are better you will repay the loan in the future. This makes you less of a risk to the lender.
Your educational background might be linked to your earnings potential in many cases. People who are more highly qualified or who have specialist degrees are more likely to secure a higher income stream which means they will have a more stable income to pay off debt. On average, the less qualified someone is, the more risk is involved of them not being able to build a financially secure life.
Car loan interest rates can be confusing. Understanding how interest on your car loan works is very important. You have to consider and take this into account when taking out a car loan. Getting a car loan as an international student will also most likely be challenging and you might not be able to get a competitive interest rate. Make sure to consider the factors and tips mentioned above when shopping for your car loan to make sure you get the best car loan for you.