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The purchase of a car is a major financial decision for most people. Most car buyers can reduce the loan amount by making a down payment or trading in another vehicle. That still leaves the need to borrow money for the car purchase and requires a basic understanding of car loans.

Car Loan Basics

Car loans are offered by most financial institutions, car dealers and manufacturers. Finding the best interest rate may require some comparative research and shopping around.

Interest rates are influenced by the current rate environment when you apply for a loan as well as your own credit worthiness. For example, if you have an excellent credit history, then lenders will offer a lower interest rate. Researching interest rates may allow for better negotiating at the time of the car purchase.

Components of the Loan

The factors that comprise a car loan include the interest rate, the length or term of the loan and the principal amount that is borrowed. The interest rate offered may vary depending on whether the car is new or used or a refinance. The term of the loan may range from one year to seven years; the longer the term, the smaller the monthly payment amount. Shorter term loans may offer lower interest rates since the lender gets back the money sooner.

How Payments Are Calculated

Loan payments are typically offered as simple interest loans where the interest charge is calculated only on the principal and not compounded. The payment is based on the amount borrowed and the interest rate or APR (annual percentage rate). Payments at the beginning of the loan will include more of the payment going toward interest and less toward principal.

Save Money on Your Car Loan

As with any loan, the sooner you pay off the debt, the better. Paying off your loan early will reduce the total interest charges being paid.

  • You can pay off the loan early by making additional payments and that will save on the interest over the life of the loan. Consider using a year-end bonus or a tax refund as a way to reduce the loan.
  • By making more frequent loan payments, bi-monthly versus monthly payments, you can reduce the interest that is applied to each payment.
  • Follow current interest rates and take advantage of a loan refinance or loan transfer if rates are falling.
  • Make the loan payment on time and avoid late penalties and fees.

Other Factors to Consider

In addition to the researching interest rates, there are other steps to consider before getting a car loan.

  • A car purchase can be an emotional decision, so try to prepare ahead of time by getting pre-approved for a loan.
  • Do a credit review by getting your credit score and credit report ahead of the car purchase.
  • Since cars depreciate in value, try to keep the loan term as short as you can afford.
  • Car expenses such as auto insurance and repairs are also important factors in the budget.

In the Driver's Seat

Before taking on any new debt, such as a car loan, review your budget and determine what monthly payment you can comfortably afford. This is a commitment that may last five years for longer, so it's best to consider the full financial impact before any final decision is made.

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