For most, major purchases like a home or car will require financing. That loan will also come with interest cost — a percentage of your loan charged by the lender for letting you borrow from them. For an auto loan, this percentage may be calculated using what is known as simple interest. By understanding how simple interest works, you may just save a little bit of money over the course of your loan.
How does a simple interest auto loan work?
Simple interest is relatively straightforward. Your outstanding principal balance is multiplied by the daily interest rate (your interest rate divided by 365) to calculate your interest payment. Essentially, you pay interest based on how much of the principal you still owe and the number of days you owe it. Before proceeding further, let’s define some of these terms.
What is a loan’s principal?
Your loan’s principal might sound like it’ll assign you detention, but don’t worry, it’s nothing sinister! The principal refers to the money you borrowed. It's the actual amount you received access to, and its outstanding balance is what accumulates interest.
What is a loan’s interest?
Interest is the amount a lender charges you on top of your loan. Interest is usually expressed as a percentage of the loan, customarily known as its interest rate.
What is a loan’s APR?
Along with the interest rate, you may see an additional percentage number advertised on an auto loan referring to the annual percentage rate (APR). This number might be exactly the same as your interest rate, but it may also be higher. That’s because APR considers your interest rate as well as certain additional fees associated with your loan. Therefore, this number can help to provide a more transparent and accurate picture of the true cost of borrowing money.
Early or extra payments on simple interest auto loans
With simple interest auto loans, your payment amount and due date tend to be consistent every month. Barring any payment discrepancies or changes to your account, your payment schedule is set up so that your balance will ideally be zeroed-out by the end of your loan.
Your payments are first applied toward your outstanding interest and any additional fees. Whatever’s left afterward is what goes toward your outstanding principal. When you pay before your due date or pay extra, more of that payment goes toward lowering your principal balance.
Late or insufficient payments on simple interest loans
A late or insufficient payment on a loan, even by a few days, may be detrimental to you as a borrower. Since interest accrues daily, a late payment means more of your money has to go toward your interest first. Consistently late or insufficient payments might even end up adding significantly to the amount you pay over the life of your loan, costing you more than you initially bargained for.
Simple interest (PDF) can make paying off your auto loan a relatively straightforward process, especially if you follow the payment schedule you worked out with your lender. Paying late, or not paying enough, may end up costing you more due to greater interest accrued. Paying early or extra, on the other hand, may have the opposite effect and potentially save you some money.