Knowing how interest, repayments and loans in general are calculated is crucial for most borrowers, and sometimes confusing.
However, you don’t need a PhD in order to understand it all.
Here’s a breakdown of the maths involved in loan and some simple examples.
Interest
When you borrow money, lenders (like banks) want to be paid for their time and services and the risk they take when lending people money.
This means you pay back the money you borrowed, plus an additional amount known as interest which is a percentage of the loan amount.
To calculate the interest amount
Note: Interest amounts follow the amortisation method. This means that interest is a percentage of the amount owing. Therefore, the interest dollar amount decreases as the loan is paid off over time.
It’s much easier to think of interest amounts as a schedule, rather than one lump sum.
Example: $20,000 loan at 5% interest with monthly scheduled repayments over a term of 5 years.
To keep it simple, we won’t add in any fees or deposits and we’ll assume the borrower follows the loan agreement without missing / delaying any repayments or making early repayments. We’ll also base this on months containing 30 days.
Here’s the formula: Loan amount owing x interest rate / 365 (days in a year) x 30 (days in a month)
For our example: $20,000 x 0.05 / 365 x 30
At the beginning of the loan term, when the full $20,000 is owing, the first repayment would include around $82.20 of interest.
The repayment for the actual loan is: Loan amount / loan term in months
In our case, $20,000 / 60 (months in our loan term of 5 years) = roughly $333.33
This means the first monthly repayment will be $82.20 of interest + $333.33 of actual loan amount repayment = $415.53
Now, the remaining balance of the loan is $20,000 - $333.33 so, $19,666.67.
To calculate the repayment due in the second month:
Using our interest formula, loan amount owing x interest rate / 365 (days in a year) x 30 (days in a month), we get roughly $80.82.
$19,666.67 x 0.05 / 365 x 30 = $80.82 of interest
Plus our loan repayment of roughly $333.33 = roughly $414.15.
You can see our total repayments getting a little lower each month. Here’s the breakdown of the first 6 months of our example:
Month | Interest | Loan Repayment | Loan Balance | Repayment |
1 | $82.20 | $333.33 | $20,000 | $415.53 |
2 | $80.82 | $333.33 | $19,666.67 | $414.15. |
3 | $79.45 | $333.33 | $19,333.34 | $412.78 |
4 | $78.08 | $333.33 | $19,000.01 | $411.41 |
5 | $76.71 | $333.33 | $18,666.68 | $410.04 |
6 | $75.34 | $333.33 | $18,333.35 | $408.67 |
Repayments are typically adjusted to be even each due date in order to make things easier for borrowers.
Note that these calculations are only a guide. Make sure to seek professional advice before taking out a loan. All loans are assessed and calculated on individual borrower circ*mstances.
Loan words meaning
Loan amount
How much you borrow. The actual dollar amount you need to purchase your asset (e.g. a car).
Example: you want to buy a car for $20,000. You have a deposit of $2,000, therefore your loan amount is $18,000.
Interest
The amount charged on top of the loan amount. This is a percentage determined by the lender (e.g. a bank). It’s how they make money from their customers, similarly how a supermarket adds a mark up on goods they sell to customers.
Interest rate
The interest rate (percentage) on a loan is not set like it is for all customers who buy goods from supermarkets. The interest rate differs from borrower to borrower.
The interest rate is determined by risk and other factors.
Example: a borrower working casual hours buying a used car will typically attract higher interest rates than a borrower with full-time employment buying a new car.
This is because the borrower with the full-time job is less likely to struggle repaying the loan, ie. their job is more secure.
Term
The length of the loan, usually detailed in months.
Example: a loan with a term of 60 months (5 years) means the borrower will pay the loan off over 60 months.
Repayments
These are the scheduled repayments made to pay the loan off. They can typically be weekly, fortnightly or monthly. If you worry you can’t make a loan repayment, know what to do.
Example: a borrower makes fortnightly repayments of $120 to pay off a loan. The repayments can usually be automatically deducted from the borrower’s bank account.
NAF
Net Amount Financed. The total amount of the loan, not including interest.
The NAF does include bank fees and establishment fees, among others.
Example: Loan amount + establishment fees & charges = NAF
Summary
If you’d like to check what your repayments look like on various loan amounts, try a loan calculator.
These are far more accurate than the calculations above and take more aspects into account.
Getting the best loan means one tailored to your lifestyle and your needs.
Understanding how it all works is a large part of making sure that getting a car loan is worth it for you.
Tom Caesar
Tom Caesar is the Managing Director of The Positive Group, a group of Australian financial services companies offering a broad range of finance to clients Australia wide. The Positive Group assist clients in the areas of car finance, mortgages, insurance & wealth management. Tom has been in car & asset finance for over 10 years. Tom regularly contributes articles on car finance, insurance, technology and business growth, drawing on his experience of starting his own brokerage in 2009.
