I received this email last week:
Hi, I was wondering if you could help me out and explain why each month the amount of my car payment applied to interest goes up and down as opposed to gradually going down? Does the time of the month you make your payment affect this? Or something else?
After a couple of email exchanges, I got the following information:
Amount financed: $16,788
Interest rate: 12%
Term: 6 years (72 months)
I plugged those into a spreadsheet to find that his monthly payment should be around $328.21. He told me his actual payment is $331.99 per month. Most likely, there’s some program included in his monthly note. He also sent me a record of his payments:
As you can see, his first payment had a ton of interest. That’s most likely due to the fact that they probably put off the first car payment for 45 days (at least that’s what I came up with). My theory is that interest on this loan is charged on a daily basis. In this case, they divided 12% by 365 and then multiply that figure by the outstanding balance and add that amount to the balance. Like this:
Then, on the date the payment is made, the current balance is reduced by the amount of the payment and the interest charge is calculated on that balance. The interest portion of the payment is simply the sum of the daily interest charges since the last payment. So, if he goes longer between payments, there will be more interest for that particular month. I came pretty close to getting the same numbers as this reader sent me.
He then asked me if there was a way to reduce the interest charges by sending in his payments early. That will reduce his interest charges slightly but to REALLY make a difference, he needs to pay more towards his principal each month. That would give him the most benefit. And, since his interest rate is 12%, it would be very wise of him to do so. According to my numbers, he will end up paying over $6,900 in interest on this loan. He only financed $16,788.
The only good thing I can say is at least he bought a Honda. I just hate seeing people with these kinds of loans.