How is Interest Calculated?
Consider buying a vehicle but finding the process daunting and challenging to navigate?
You’re not alone! The good news is, at Direct2Wheels, we’re here to provide all the answers to help your car-buying journey go much smoother. For example, you may be wondering about the particulars of how a car loan works. It helps to understand the mechanics (pun intended) before you apply for a loan because you can increase your odds of approval.
How is interest calculated?
First let's understand who the players are.
THE PRINCIPAL is the initial loan size; it can also be the amount still owed on a loan. If you take out a $30,000 loan, for example, the principal is $30,000. If you pay off $10,000, the principal balance now consists of the remaining $20,000.
THE INTEREST RATE is the amount a lender/bank charges a borrower and is a percentage of the principal—the amount loaned. Depending on your credit score, the vehicle itself and the term of the loan, this number can be anywhere between 0% and 20% (learn about how your credit score is calculate here)
You may be tempted to take the principal amount of the loan and multiply it by the interest rate. Well, the actual process is a little more complicated than you might expect.
Interest on a car loan is calculated daily!
The interest rate is divided by 365 – the number of days in a year. This number is known as the interest factor. Next, the principal loan amount is then multiplied by the interest factor. This number is called the daily interest charge. With us so far? This amount is added to the principal loan amount every day until your monthly payment is made. Your payment goes first to the interest accrued and then to the principal. Then, the daily interest charge is recalculated based on the new principal loan amount, and the process repeats itself each month for the term.
Okay, let’s break this down even further! Time for some Math..
Example: Principal Loan Amount $20,000 interest rate of 7.95%
Step 1: 0.0795 / 365 = 0.000217808 interest factor
Step 2: 0.000217808 * 20000 = $4.36 daily interest charge
Step 3: $4.36 * 30 days to payment = $130.68 interest accrued in first 30 days
Now if you have have a $500/month payment you would subtract the interest accrued, $500 - $130.68 = $369.32. This is the amount of your payment that goes towards principle. So now the new principal outstanding is $19,630.68 ($20,000 less the $369.32). The following month starts the process again, but now uses the new principal amount to calculate the daily interest charge.
Making extra payments can save you interest!
It’s best to make additional payments on the same day that you make your regular payment. That way, everything extra goes directly towards the principal of the loan. If you make extra payments at other times of the month, you will first pay any accrued interest before the amount goes towards the principal. With most banks, you can even set your auto-debit payments to be more than the minimum payment to ensure you save even more interest. You only have to make the minimum payment, but you can make extra payments anytime. As a result, you will pay off your loan faster and save substantially on interest charges.
If you dream of owning a newer vehicle, but poor credit is getting in the way of making it a reality, we can help. At Direct2Wheels, we have a variety of options available. So, let’s talk, and let’s help get you into a quality vehicle that suits your requirements and your budget.