Monday, July 03, 2006

Vehicle Loan Payments

Buying a new vehicle can be a fun as well as financially frustrating time. While searching for the car of your dreams, you don’t want to end up with a budgetary nightmare! When looking to take out a loan one should be primarily concerned about how much you can afford to pay back on a monthly basis and for how many months. Of course you want to get a reasonable price deal on the item or service to be purchased, but you also must be able to afford to pay for it over time.

Key factors:

Loan amount or principal: This is the driving force in determining affordability. An item’s costs must fall within your means to pay for. You can reduce this cost by the use of a down payment and/or trade-in. You can also attempt to negotiate a better price. However, at the end of the day the principal amount must lead to an affordable monthly payment.

Interest rate: Interest charges reflect the cost of the loan in dollars and cents i.e. the cost of borrowing money. While the principal amount will have the most impact on your monthly payment, you also want to keep the interest rate as low as practical. Interest rates for loans can vary widely at any given point in time. Your credit rating will have the greatest impact on your ability to take advantage of the best rates available. Also, such factors and dealer financing or credit union direct payments/ direct deposit of salary/pension checks, etc. can reduce loan rates by a quarter of a percent or more. Also shorter loan periods tend to offer lower rates.

Number of months for repayment: The longer you take to pay for a given loan; the lower the monthly payments tend to be. However, you never want your loan to outlive the item that was purchased! Also, you need to take into account future obligations that may need access to those loan payment dollars. With the exception of a house, your loans should generally be no longer than five years. A possible exception might be a large motor home, or yacht.

Monthly Payment: People often use the other factors above (principal, interest rate, and number of months) to determine the monthly payment needed. However, I recommend that the payment be your starting point in determining affordability. This is the item you need to set up first, then proceed to check on loan rates/durations and then calculate associated principal dollar limitations.

Other factors:

In addition to the above items, some loan terms include origination fees, annual fees, insurance fees, etc. All such charges and fees should be avoided. Do not enter into any loan agreement that contains any such language.

Also there could be some type of early pay off penalty i.e. if you choose to include extra payments you could be penalized by way of additional charges and fees. Such a loan agreement should also be avoided.

For vehicle purchases a very important consideration is insurance. The acquisition of a new car will most likely cause your auto insurance bill to go up. Be sure to check with your policy company and get estimates for each type of vehicle that you are considering. Don’t assume that vehicles that you consider similar are treated the same by the insurance company. There are many factors that go into the computation of insurance premiums so be sure to include the make and model of each one for an estimate. You need to have room in your budget to handle an increase in your insurance cost. Also, if you plan on keeping an older vehicle for use by another family member under your policy (e.g. a child), then you need to take into account the impact on your premium which could be significant.

Loan independence
While the company offering the item for sale often provides loans, one should always have an independent source from which to get a loan quote. This will allow you to compare the cost of the item to the cost of the loan. Issues such as rebates, miscellaneous fees, potential penalties and other dollar related issues can be looked at apart from the actual selling price of the product. In theory, if you get independent financing, the actual price of a given item should be less than if you elect some type of dealer loan offer. At the end of the day, you may still elect to choose dealer financing, but you should always have an independent loan offer to compare it with.

Pre-computation of key amounts
You should always come up with payment estimates, prior to getting serious about closing a deal on a item that requires a loan. Formulas to determine payments are rather complicated, but there are functions in spreadsheet programs and calculators on the Internet that can be very helpful. Here are the recommended steps:

1. Determine the maximum monthly payment that you can afford to make for the item in question. This dollar amount must be available within your budget month-after-month. Don’t be over optimistic on income sources or your ability to cut back on other expenditures to come up with this payment amount.
2. Determine the number of months that you can sustain such a payment. The ideal answer is “indefinitely”. However you must be realistic here. If you know of obligations that will be coming up in a few years such as a child starting college, or kindergarten for that matter then you must take the financial impact of such an event into account.
3. Develop a list of potential loan offers including interest rates and durations.
4. Determine an estimated loan dollar amount needed i.e. the cost of the item to be purchased. Appliances can be estimated fairly easily while the out the door cost of a vehicle can be much harder to determine. However, it is vital that you come up with a reasonable upper limit cost here.
5. Confirm that month payments and time limits are realistic for the available loan terms and estimated purchase price. Using the results from items 3 and 4 you can determine if you can match them to your item 1 and 2. That is, your maximum affordable monthly payment for your maximum number of months falls within a give set of loan terms for the needed purchase price.

Let us walk through the above issues with a specific example:

We are looking to purchase a new vehicle and can afford to pay $400 per month for sixty months within our given budget. This gives us the answer to items 1 and 2 above.

We look at several potential loan offers available for sixty months:

Zero percent (from the dealer)
5 percent from our credit union.

Note, the dealer offers $4,000 in rebates in lieu of zero percent financing.

We now have information on item 3. Next, we must develop a realistic cost of the vehicle. This should be done independent of financing issues i.e. without considering such things and trade-ins or rebates. Be sure to include items such as destination charges, sales taxes, dealer preparation, alarms, and any add-on warranties that you are interested in. Let’s say this estimated total is $25,000. We know have input for item #4.

Next we can work on item #5. Let’s consider the Dealer financing offer followed by the Credit Union rates.

Dealer Financing at Zero percent
This one is easy to compute since there is no interest to take into account, simply divide the loan amount by the number of months:
$25,000 / 60 = $416.67

We can see that we are in trouble right off the bat! The computed payment is $16.67 per month over our maximum. While this is a relatively small amount (compared to $400), it is still over. We don’t want to be over. Our maximum amount should have been chosen with a small amount of pain in mind – we don’t want to introduce any additional pain.

However, we may have a trade-in or may think that we can negotiate here. Let’s see how much we need to get down to achieve our maximum of $400/month. To do this, multiply by the number of months to get $400 x 60 = $24,000. Then subtract from the estimated cost $25,000 - $24,000 = $1,000. Hence if we can get $1,000 for our trade-in and/or/combo negotiate the price down then an affordable deal can be achieved.

Credit Union at 5.0 percent
Next look at the Credit Union plan of 5 percent for 60 months. In this case we need to adjust the cost of the vehicle to take into account offers such as rebates that in our example includes $4,000. Hence the loan amount is reduced from $25,000 to $25,000 - $4,000 = $21,000. To compute the loan payment one needs a special electronic calculator, spreadsheet formula or Internet calculator or the table in the appendix of my Basic Budgeting Concepts book. The result is $396.29 per month. In this case, the result yields an amount below are limit of $400 per month without any special gyrations! Of course, one should still use a trade-in if desirable, and one should always work to lower the out the door cost, but we can have the confidence that the vehicle can be acquired.

For the above example, be sure to perform all calculations before sitting down with the dealer to negotiate the final deal. You need enough information ahead of time to come up with a reasonable purchase price and you need to get pre-approved from your Credit Union for the loan terms. However, you don’t want to commit to any thing until after you’ve completed your calculations in a quiet place (home is best), but away from distractions). From the example above, we can see the potential power of rebates and/or hard price negotiations with the dealer.

The hard part in the above calculations is item #5, determining the monthly payment calculation. Below are ways to do this in EXCEL and some recommended Internet loan calculators:

First of all, you should already be comfortable in using this spreadsheet program; otherwise, I recommend that you pass this approach by. Within EXCEL there are two functions useful in computing loan information:

PMT the payment function. It will compute the monthly payment for a given interest rate, number of payments, and loan principal. The formula is entered as “=PMT(rate,nper,pv)” where:

Rate: the interest rate stated as monthly interest. For example, if the rate is 5%, then it should be stated as 5%/12 or .05/12 or the calculated result of .0042. I recommend using “5%/12” for readability.

Nper: This is stated simply as the number of months for the loan duration e.g. 60.

Pv: Present value or loan principal is stated as the amount of the loan e.g. $21,000.

The answer returned in the spreadsheet cell is the monthly payment stated as a negative amount. For example for 5% interest, 60 months and $21,000 the answer is given as -$396.30 i.e. a negative number.

PV the present value function It will compute the initial loan principal for a given interest rate, number of payments, and payment amount. The formula is entered as “=PV(rate,nper,pmt) where:

Rate: is the interest rate as stated above.

Nper: Ths number of payments as stated above.

Pmt: The monthly payment as a negative number. For example enter $396.30 as “-$396.30”.

The answer returned in the spreadsheet cell is the initial loan value amount. Note, if you enter a positive number for the payment (pmt), then the answer will be correct, but negative.

The PV or present value function can be very useful in determining the answer to item #5 above. Since you already know the maximum payment your budget can afford, you can use your loan terms information to calculate the largest principal you can afford to borrow. Comparing this amount to the actual cost of the vehicles you are looking at will let you know whether you can reach a deal.

Internet Calculators.
Listed below are some websites that contain loan value calculators.
Sponsored by This calculator is very straightforward, but can be used to compute monthly payments only.
Sponsored by Time Value Software. This calculator will compute the value for the box you leave blank. Hence it can be used to calculate either the monthly payment or initial loan amount. Note; leave the following boxes at zero:
Points; Fees; Pre-paid Interest days
Sponsored by USA Today. This web page will have a variety of calculators. Select “Autos” for car loan selections. You will get a pop-up list with a variety of options. For payment calculation select: “How much will my vehicle payments be?”. For loan amount calculation select: “What car can I afford?”. When the appropriate calculator comes up, fill in the appropriate boxes. I recommend that you leave down-payment and rebate boxes blank, to focus in on the out the door cost to you. You can always fine tune your calculations later is desired.
Sponsored by State Farm Insurance. These calculators are very similar to the ones under USA Today, but seem to be easier to access for the Auto Loans. The initial web page includes a variety of calculators with the Auto Purchase ones listed first.

To get more calculator sites, I recommend using Google® with a search for “loan calculators”. You will get a long list. Don’t be afraid to search page after page for one that catches your fancy. As with all searches be wary of websites with pop-up ads, deceptive links and excessive advertising.

Now you are armed with tools that can let you determine how affordable a give purchase is in terms of your personal budget. If you spend time on the factors needed to develop a scenario that you can live with, then you have an excellent chance of success. Such information will allow you to get the best deal while staying within your means. Good hunting!


Blogger Sylvia Hubbard said...

WOW! I didn't know i could learn so much! thank you Robert,for the great knowledge you're sharing!

7:17 AM  

Post a Comment

<< Home