How Are Car Loans Calculated?
Generally, there are two types of car loans: "personal" loans, and leases. Personal loans can take a number of forms and the information in this page refers to that type of loan.
Personal loans for cars generally use the principal and interest method to calculate what your repayments would be. This means that with each repayment you make, a proportion of your repayment is principal (which is the term used for the borrowed amount), which reduces your balance and the other proportion is the interest component.
As your repayments are a set amount each month, in the earlier stages of your loan, the interest component would be at its greatest, which actually seems like your balance is not reducing much due to this, as your principal amount is at its smallest in those earlier stages.
This gradually changes the further you get into the loan, where at the end of the term, the principal component is at its greatest, and the interest component is at its smallest, unlike the beginning of your principal and interest loan. This is referred to as amortisation.
Borrow amount is $20000 (which includes any fees and charges for the purpose of this example) over 5 years at an interest rate of 10% p.a. fixed (means this rate stays the same for the whole 5 years).
This would equate to 60 equal monthly payments of $424.94 if you were to use a car loan calculator.
The 10% p.a. rate would calculate interest on the daily balance, which is then charged back to the loan, monthly in arrears, or at the end of the month.
Month 1 – Daily Balance is $20000, therefore interest on this amount is $20000 x 10% = $2000 / 12 months, which equates to $166.67 in interest. From your monthly repayment, only $258.27 would be principal and reduce the balance. (Principal calculation is:- set monthly payment of $424.94, minus interest component of $166.67 = principal component of $258.27)
Month 2 – Daily balance is $20000 - $258.27 (principal from month 1) = $19741.73. Interest on this amount is $19741.73 x 10% = $1974.17 / 12 = $164.51. Therefore the principal component would be $260.43, leaving an outstanding balance of $19741.73 - $260.43 = $19481.30 for the calculation of interest for month 3.
As you can see the interest amount was smaller in the second month due to the balance reducing, which also increased the principal component. This magnifies the further you get into the loan.
Benefits of Additional Repayments
The above example is simplified to make it easier to understand, but if you made additional repayments, this would reduce the balance of the loan on that day, which would also decrease the interest component in your set repayment. You should check to see if your contract allows you to make additional payments without penalty.
As the interest is actually calculated daily, the correct method would not be to calculate the balance x interest rate / 12 months. The correct method would be to calculate the balance x interest rate / 365 days x the number of days in that month, understanding every month is different. (Some lenders will even go as far as using 365.25 days in a year to take into account a leap year every four years)
You repayments would not reduce as a result of additional repayments, but your loan would be paid off quicker and also reduce the total amount of interest payable over the full term of the loan. The earlier into your loan that you make additional repayments, the greater the benefit, due to the balance of the loan being at its greatest, which means the interest component would also be at its greatest. Any additional repayment will reduce the balance of the loan on that day which is used for the interest component calculation.