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6.2 Computing Interest Rates
Understanding how to compute interest rates is essential if you’re going to be involved in arranging financing for your customers — and most retail dealers are. The interest rate on a vehicle loan is typically expressed as an annual rate, but interest accrues monthly. Let’s walk through the basics.
The simple interest method calculates interest on the outstanding principal balance. Each month, the interest charged is calculated by multiplying the remaining principal by the monthly interest rate (which is the annual rate divided by 12). In the early months of the loan, most of the payment goes toward interest because the balance is high. As the balance decreases over time, more of each payment goes toward principal — this is called amortization.
For example, if a buyer finances $20,000 at 6% annual interest for 60 months, the monthly interest rate is 0.5% (6% divided by 12). In the first month, the interest charge would be $20,000 times 0.005, which equals $100. The monthly payment on this loan would be approximately $386.66. So in the first month, $100 goes to interest and $286.66 goes to principal, reducing the balance to $19,713.34. The next month’s interest is calculated on this lower balance, so more goes to principal. This cycle continues until the loan is paid off.
You should be able to explain this process to your customers at a basic level. Many buyers don’t understand how amortization works, and a clear explanation builds trust and helps the customer make an informed decision about their financing terms.