Today we are going to discuss how car payments work. Have you ever looked at your auto loan balance and wonder why the principal does not seem to drop at a fast rate even though you are paying more than the required payment? Ever wonder how much interest is being paid on a monthly basis and how that interest is calculated? Wonder how you can actually pay it off faster than expected or at least make a dent into the principal of the loan? Well if you have asked these questions, hopefully this series of blog will provide you with some insight that can help you and your loved ones.
Everyone knows that every loan from a commerical lender has some sort of interest rate attached. This is how the bank makes money on the money they lend to individuals. Some may pay a lower or higher interest rate due to your credit rating, down payment, or terms of the loan, etc. Regardless of what that interest rate, here is the formula that one can use to pay down this debt faster.
Let's use this example:
Say after everything is said and done the amount of the loan to be financed is $25,000 and you are paying 10% interest on the loan financed over 5 years (60 months). Using these terms your monthly payment would be $531.18. Now I am sure most people do not want to pay that note for five years, so the first thing we need to calculate is how much interest the loan is incurring on a monthly basis.
To calculate that do the following:
Step 1:
- Take the annual interest rate, which in this case, is 10% and divide that by the number of months in a year which is 12 (months) and that would equal .008333 or .8333% interest a month.
.1(annual interest rate converted to a decimal)/12 (number of months in the year) = .008333 (monthly interest rate converted to a decimal) or .8333% (monthly interest as a percent)
Step 2:
Next take the monthly interest and multiply it by the principal due for that month; so for this example let's say this is your first car payment that is due. That means that the full $25,000 is owed and is eligible to earn interest. For the first month you are responsible for $208.33 in interest.
$25,000 (outstanding loan balance due for current month)*.008333 (monthly interest rate converted to a decimal) = $208.33 (total monthly interest due rounded to the nearest cent)
Now to figure how that affects your car not follow step 3:
Step 3:
Take the monthly car payment of $531.18 and subtract that from the total montly interest due which is $208.33.
$531.18 (monthly car payment) - $208.33 (total monthly interest due)= $322.86 (the amount of the car note that will be applied to lower the auto loan due)
What this means is that when you make your first car payment this month $322.86 will go to the principal and $208.33 will go towards interest.
Step 4:
Once you make this payment, under this scenario, month two the interest will be calculated on an outstanding loan balance of $24,677.14.
$25,000 (outstanding loan balance due for current month) - $322.86 (the amount of the car note that will be applied to lower the auto loan due)= $24,677.14 (outstanding loan balance for the month)
Step 5:
Now to determine how much interest is due next month take the outstanding loan for the next month in this case it is $24,677.14 and repeat steps 2 - 4 here. That means $205.56 in interest would be due for the next month.
$24,677.14 (outstanding loan balance for the month) * .008333 (monthly interest rate converted to a decimal) = $205.56 (total monthly interest due for next month)
That ends today's lesson and now you should be able to determine how much of your car payment actual goes to interest and how much will go to pay down the auto loan. Now in our example we used a scenario as if no payments had been made, however, it does not matter how much is left on the loan or how many payments you have made already. Just plug in your information and now you can see what the bank sees each time you make a auto loan payment.
Next lesson will answer that question how to pay off my auto loan faster.
Feel free to post your questions below if you have any and I will be more than happy to respond to them... Good Day, Good Luck, and Good Saving....
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