How Does Car Loan Interest Work In Canada? Everything To Know

Auto loan interest is simple in principle but more difficult to work out in practice. Yet it determines how expensive it is to borrow and how much you’ll be paying each month.

We asked our auto loans team to answer the question "how does car loan interest work?". We all make better decisions when we know what’s going on!

How Car Loan Interest Works

When you take out an auto loan, the lender gives you the money to buy the car, or buys it for you and you repay them over time. The interest they charge is their fee for lending you that money, plus a little to help cover the risk of lending.

Most auto loans use simple interest. That means the interest is applied to the principal, the amount you borrow, without compounding or any other financial trickery.

Your typical monthly payment will be made up of a portion of interest and a portion of principal. The exact amounts are broken down depending on how much you borrow over how many months.

Where it gets tricky is how that interest is worked out.

The interest is calculated on the day the payment is due.

For example, you borrow $25,000 over 48 months at 4%. Your first month would include interest for the full $25,000.

Your second month would include interest for $24,650 as you paid off some the first month. The third month would charge for $24,400 and so on.

It would reduce each month as you pay off the amount you borrowed.

Auto Loan Interest and Amortization

That interest is usually amortized. That means you pay more interest than principal at the beginning of the loan and it slowly evens out as you get into it.

The further into the loan you get, the less interest and the more principal you’re paying. The monthly payment stays the same but the percentage of what you’re paying changes.

For example, the first year of the auto loan above, if your first month’s payment was $350, around $85 would be interest. Halfway through your loan, only $40 of that $350 payment might be interest and at the end, perhaps only $5.

These figures are obviously just for illustration, but you can see how the system works.

Lenders amortize loan interest to make sure they get their cut. Few people default on loans early on so the lender makes sure to get their return early.

Then, once the majority of their money has been made, the payments gradually shift until you’re paying off the bit you’re interested in. The principal.

There are other types of interest, like compound or precomputed but the majority of loans use simple interest. It’s the fairest type of loan that balances lender profit with being affordable and fair to borrowers.

We hope this helped you understand how car loan interest works. If you’re interested in taking out a low interest auto loan, one of our team will be happy to help.

For those of you who know that you have a challenging credit situation, please visit Dixie Auto Loans where we have a team of credit specialists ready to help you get approved for a car loan today!