What Is A Simple Interest Auto Loan & How Does It Work?

PeopleImages/Getty Images

Auto loans are a common option and are available through traditional banks, credit unions and online lenders, but they’re not all the same. Beyond the varying loan terms each lender offers, you’ll also need to consider how the lender calculates interest before you apply.

Simple interest auto loans are standard and have several benefits that make them more attractive than precomputed interest auto loans. They are much more common, and in general, making extra payments on simple interest auto loans can help you pay less interest over your loan term.

How a simple interest auto loan works

Simple interest auto loans have fixed monthly payments that apply to both the principal balance — the original amount you borrowed — and the interest that has accrued over the month. Using simple interest is typically less expensive for the borrower than compound interest, where you also owe interest on the previous accumulated interest.

When you initially take out a simple interest auto loan, more of the monthly payment is applied toward the interest than the principal. As you pay down the loan, a larger portion of the monthly payment starts to go toward the principal. The amount you are charged in interest decreases as the outstanding loan balance shrinks.

For example, consider a $36,000 auto loan with an interest rate of 6 percent and a four-year term. You’ll pay about $845 monthly and $4,582 in interest over the life of the loan. Interest is calculated by multiplying the outstanding principal balance by the annual interest rate and dividing that by 365. The amortization schedule breaks down how much of your payment goes toward interest versus your principal balance.

When you’re comparing loan options, use an auto loan calculator to determine your total interest costs based on the terms you receive.

Benefits of a simple interest auto loan

Simple interest auto loans come with a few key advantages that make them a popular option.

• More affordable payments: Since the amount of interest you pay each month is only based on the principal balance, you may have lower monthly payments than you would if the lender used compound or precomputed interest.

• Sizable cost savings: If you decide to pay the loan off early, you could save on interest. For example, an extra $100 each month can cut hundreds of dollars off your interest bill — and shorten your loan term at the same time.

• Commonly offered: Simple interest auto loans are the most common type of auto loan, which makes it easier to find a lender that suits your needs and offers competitive terms.

How to save on a simple interest auto loan

By paying more than the minimum every month, making on-time payments and signing up for autopay, you may be able to cut down on the interest you pay.

• Pay more than the minimum: Paying extra each month or even doubling up on the payments can help you reduce the principal balance faster and pay off your loan earlier.

• Make timely payments: If you fall behind on loan payments, you could be charged late fees and accrue additional interest on your simple interest auto loan.

• Sign up for autopay: Autopay helps you avoid missing payments, and some lenders even offer a rate discount for using the autopay feature.

• Check for prepayment penalties: While rare, some lenders charge prepayment penalties. This can limit your savings, so review your loan contract carefully to avoid added fees.

Bottom line

With simple interest auto loans, you could have lower monthly payments and you may be able to save money on interest if you are able to pay your loan off early. When you’re ready to move forward, compare auto loan rates with reputable lenders. And make sure to prequalify or be preapproved with at least three lenders before signing on with one.