When a consumer finances a vehicle, he wants to pay it off as soon as possible and to avoid paying a large amount in finance charges. Unless he receives a zero percent financing, a finance charge on his car loan will depend on the interest rate and the way the financial institution calculates the interest.
Car Loan Basics
When a consumer applies for a loan, a lender reviews his application and a credit report to evaluate his creditworthiness. Based on this information, the lender determines how much a consumer can borrow and the interest rate for which he qualifies. The financed amount may include the cost of the vehicle, taxes, fees and other charges, such as credit insurance and extended warranty. A consumer may need to pay part of the fees out of pocket. Based on a borrower's creditworthiness, a lender may request a down payment or a co-signer.
Finance Charges
A finance charge is a cost of a having a car loan. A financial institution calculates a finance charge based on the interest rate, also referred to as annual percentage rate or APR, and the length of the loan. The longer the term of a car loan, the more a consumer will pay in finance charges. The higher is the loan amount, the higher is the total amount of finance charge. Finance charges may include other fees, such as late payment fees, returned check fees and pre-payment penalties, when applicable. A consumer must receive a copy of the loan contract which describes how finance charges are calculated.
Simple Daily Interest
Most financial institutions use a simple daily interest, also known as simple interest, method to calculate finance charges on a loan. A lender can provide an amortization schedule that lists how a bank will apply loan payments each month with respect to principal and interest. Loan statements also list the breakdown of loan payments each month. If your lender uses simple daily interest method, your interest calculation depends on the balance of your loan. If you pay extra, your loan balance will decrease and your interest charges will be less each month. The creditor will apply more of your payment towards the principal.
Front-Loaded Interest
Some banks front-load loans by calculating the total finance charge for the whole term of the loan and adding it up front. As a result, a consumer pays mostly interest for the first two years of the loan. If your bank uses this method, you will pay the same amount in interest. It even becomes a disadvantage for you as you will pay the same finance charge whether you pay the loan off in three years or five. A bank may charge a prepayment penalty if you pay off a loan early.
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