How to calculate the cost of an Auto Loan
How to calculate the cost of an Auto Loan
Not everyone can pay cash for a new car, most of us take out a loan to pay for the car of our dreams or even to buy your first second-hand motor vehicle. Auto loan calculators are freely available to help you estimate the cost of borrowing, so that you can work out the best auto loan to suit your budget.
It doesn’t matter who you are, what your status is or where you live. When you take out a loan, whether it’s a car, home or credit card loan, you will pay back both the amount you borrowed and any interest that has been added on top of it.
An auto loan is a short-term personal loan
An auto loan, or car loan, is a type of short-term personal loan, which is used for purchasing a car. It works just like any other secured loan granted by a financial institution. Once you take a loan, you will be making monthly repayments on the principal amount and the interest. The main difference between a standard short-term loan and an auto loan is its purpose. In the case of an auto loan it is strictly defined; you can only use it to purchase a motor vehicle.
Another difference is that car loans have built-in collateral – the purchased car. So, if you are unable to pay the instalments and pay back the borrowed money, the car will then be legally repossessed by the lender.
Car loans also differ strongly from a mortgage loan because you do not need any real estate or collateral to apply for it. In addition, the loan granting process is less complicated and a lot shorter in the case of auto loans. Another difference is the time in which you have to payback: in the case of mortgages it could be as long as 30 years, however the typical term of a car loan is between 12 to 60 months. You can also calculate your monthly payments for your mortgage.
How does a car loan work?
Essentially this is a lot easier than many people think. Once you find the car you want to buy, you will know and understand its price. Basing the calculations on that price you should then be able to work out the amount you need to borrow. In the most simple, easiest case, it is the price of the car minus the amount of money you have. As stated above, you must work in the cost of the loan as well.
A car loan allows you to borrow the fixed amount you need to purchase the chosen vehicle. After you have made the purchase you will have to repay it in fixed monthly payments, usually over five years. The interest rate is typically constant over the entire lending period and depends on how much you are borrowing, the general rule is that the smaller the amount you borrow, the higher the interest rate will be.
When you are considering taking a car loan, it is worth knowing that there are two main types of financing on a car loan: Direct lending or dealership financing.
- Direct Lending takes the form of a typical loan from a bank or credit union. You essentially sign a purchase contract with a car dealer and then use the money borrowed from the direct lender to make the required payments.
- With Dealership financing, it is a car dealer who takes control of the process of taking a loan and doing all the required paperwork. In dealership financing you usually cannot choose the lending institution – the loan is granted by what is called a “captive lender” who is associated with the car manufacturer.
Calculating the Interest on your loan
Essentially, interest is a fee that you will pay for using the bank’s money. It’s how lenders make their profit from giving out loans. No one lends money straight from their pockets, without a profit.
The repayments that need to be made on your loan will be made up of two parts: the first is one that reduces your balance to pay off the loan, the second covers the interest on the loan.
How much interest will you pay?
In order to start using a loan calculator you’ll first need to know a few basic facts about the loan before calculating how much interest you need to pay. This information should be freely available to you before you take on the loan.
Step 1: Determine the principal amount
The first amount we are going to look at is called a Principal Amount which is the amount you’re looking to borrow. However, it’s not exactly as simple as deciding how much you want to borrow. It is more important to focus on how much you can afford to pay back on a monthly basis. In order to work out the details as accurately as possible, take your budget into consideration on all levels – yearly, monthly and weekly.
It is also a good idea to think about any life changes you might encounter over the term of the loan, such as moving to a new home or planning to have a child. It is very important to work out your budget now to include these plans so you can ensure you do not take on too much debt. Maybe you could forgo the dream car for something more affordable; remember that living beyond your means can get you into financial trouble.
Do your research and make use of expert online banking advice.
Step 2: Determine the term or period of the loan
You need to decide on the length of time you will take to pay off the loan. Shorter term loans will usually mean higher repayments, but less interest in the long run. Longer term loans will lower monthly repayments, however cost more in interest over the entire lifespan of the loan.
For example, let’s say that you are thinking about taking out a loan of $20 000 at 8.75 per annum, you would pay:
$634 per month, adding up to $2812 in interest over 3 years or;
$413 each month, adding up to $4765 over 5 years.
Step 3: Decide on the repayment schedule
On almost every loan, you will have the option to make weekly or monthly repayments. Which one you choose will depend entirely on your budgeting style. More repayments essentially mean less interest, because of compounding, weekly repayments will save you more money on interest in the long run. Although before you entirely commit to a weekly repayment schedule, make sure that you have the budget to meet it.
Step 4: Determine the repayment amount
When you do make your repayment, not all of the amount actually goes into paying off your loan. A certain amount will go towards paying the interest first and then what’s left over goes off the loan principal amount. Because the amount of interest you pay depends entirely on what your principal amount is, in order to calculate ongoing interest costs, you will need to know the amount you’re making in repayments. That is why it is so important to do the calculations, comparing the different payment scenarios.
Step 5: Calculate the interest rate
When attempting to calculate interest on your loan, remember to use the Annual Percentage Rate (APR) and not the advertised interest rate – there is a difference between the two. The advertised rate is used to calculate the interest expense of the loan; however, it does not consider other costs like broker fees, closing costs, rebates and discount points. Use the APR to get the most accurate numbers possible.
Before we get to the actual calculations it is important to understand what a car loan is and how it works…
What are the pros and cons of taking an auto loan?
It is important to understand both the pros and cons before deciding on going forward you’re your auto loan. It is better to be informed and prepared vs uninformed and out of pocket.
- Auto loans are very simple products and are easy to arrange and understand.
- They are flexible – you can choose the payback period from one to five years.
- You become the legal owner of the car right after purchase (if you keep up with your monthly payments).
- From the seller’s perspective you are a cash buyer, so you have a stronger position in price negotiations.
- If you do not have a good credit score, you will not get a car loan.
- The monthly instalments might be higher than other forms of financing for example, leasing instead of owning will always be cheaper.
- Unless the car is on warranty, you are responsible for the service and all the repairs of the vehicle.
- Due to depreciation, each year your car will be worth less. When you eventually decide to sell it, it will be cheaper than what you paid for it at the time of purchase.
Let’s look at the formulas
A few points are key here where the interest rate is given for a yearly period and the loan amount is the amount of money you need to borrow. In order to calculate the monthly payment required we will be using this formula:
- Monthly payment = (loan amount) * (interest rate / 12) / (1 – (1 +(interest rate / 12)) ^ (- loan term))
In order to calculate the amount of money you need to borrow we will use this formula:
- Loan amount = price of the car – money you have – (trade in value * (1 + sales tax))
The key points here are:
- Price of the car – the final purchase price.
- Money you have – the deposit you will pay.
- Trade in value – the value of your current vehicle.
- Sales tax – the sales tax rate.
Calculating interest on a car, personal or home loan
These loans are called amortizing loans, which essentially means that the mathematical geniuses at the bank have worked them out so that you pay a set amount each month and at the end of your loan term, you’ll have paid off both interest and the principal loan.
In order to work out how much interest you’re paying up we will be using this formula (remember to ensure you use the APR):
- Divide your interest rate by the number of payments you’ll make in the year (interest rates are expressed annually) so, for example if you’re making monthly payments this value will be determined as 12.
- Multiply it by the balance of your loan, which for the first payment – essentially the principal amount.
This in turn gives us the amount of interest you will pay in the first month.
For example, on a personal loan of $30 000 over a period of 6 years at 8.40% per annum and making monthly repayments:
- (0.084 ÷ 12) x 30 000 = 210
Because you’ve now begun to pay off your initial principal, to work out the interest you will need to pay in the following months, you need to first calculate your new balance. So then:
- Principle – (repayment – interest) = new balance
Minus the interest you just calculated from the amount you have repaid. Which then gives you the amount that you have paid off the loan principal.
Deduct this amount from the original principal to find the new balance of your loan.
It’s also important to keep in mind that doing these calculations yourself means slight discrepancies due to rounding and simple human error, however this calculation should give you a pretty decent idea of the amount you are paying in interest each month.
Auto loan calculator example of calculations
Now that we know the formula in the car loan payment, we can perform a sample calculation.
Firstly, let’s say you would like to purchase a five-year-old vehicle which is worth around $20 000. You also have a car which is worth around $7000, and $1500 in your savings account. The sales tax for example is about 10%, and the interest rate in the car loan is around 4%. You want to take a three-year loan.
In order to calculate the monthly payments, we will stick to the following steps:
- Estimate the amount you will get for your old car. Which is its trade in value minus the tax or: $7000 -$7000 * 10% = $6300
- Calculate the amount of money you will be required to borrow. It is the value of a new car minus the money you get from selling the old vehicle and money you can withdraw from your bank account: $20 000 – $6300 – $1500 = $12 200
- Use the formula shown above to calculate the monthly repayments:
($12 200) * (4$ / 12) / (1 – (1 + (4% / 12)) ^ (-36)) = $360.19
- This is your monthly payment in the loan from the above example.
- If you want to find out the total cost of your loan, multiply your monthly payment by the number of months you will pay your loan and the subtract the total amount of the loan from the values: $360.19 * 36 – $12 200 = $766.93