Simple Interest Car Loans in Canada: What You Need to Know

They may call it simple car loan interest but it can be anything but.

Compared to how complicated other financial products are, car loans may be simple but they can still provide quite the challenge to fully understand!

That’s why we tasked our auto loans team to explain how car loan interest works and how it’s all calculated. This is what they came up with.

Simple Interest Car Loans in Canada

Simple car loan interest is actually the name for the type of interest placed on many car loans. Simple interest is applied to the amount you borrow, the principal, and is usually the fairest type of interest.

When you take out a car loan, the lender gives you a large sum of money to buy the car. The car is used as collateral and the loan is secured against it. That means, if you default, the lender can take the car as part of payment.

Your monthly payment will be made up of a percentage of interest plus a percentage of the loan principal. The exact amount depends on how much you borrow over how many months.

It’s typically the loan amount plus interest and fees divided by the number of months you’re paying.

Calculating a Simple Interest Car Loan

So far, so good. But now it gets a little tricky.

Simple car loan interest is calculated on the day the payment is due. This will reduce slightly month by month as you pay more and more of the loan off.

For example, you borrow $25,000 over 48 months at 4%.

• Month 1: Payment and interest on the full $25,000 = $350 - $100 interest $250 principal
• Month 2: Payment and interest on $24,750 = $350- $99 interest $251 principal
• Month 3: Payment and interest on $24,500 = $350- $98 interest $252 principal

This is for illustration purposes, as the interest won’t reduce quite so much, but you get the idea.

The change in interest is partly due to the reduction in principal, the amount you’re paying interest on and amortization.

What is Car Loan Amortization?

When you take out a car loan, you’re not paying the same amount of interest and principal each month. Interest is front-loaded, so at the beginning, you’re paying a higher proportion of interest.

As time goes on, the amount of interest included in your monthly payment reduces while the amount of principal increases. This is the same for the majority of auto loans.

This is to ensure the lender gets their cut. People default less at the beginning of a loan and more often later. Adding their cut early means lenders protect themselves from potential loss.

In the above example, at the beginning of your car loan, you could be paying $100 per month in interest. Halfway through, it could be $50 and at the end, perhaps just $1.

The rest is made up of the actual amount you borrowed, the principal.

And that’s basically how simple interest car loans work in Canada. As we said, they may call it simple interest but it’s not as simple as lenders make out!

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