Car payment calculation | | Car buying | Financial Literacy | Khan Academy

So let's think a little bit about how you might likely pay for a car. Now, there's really three ways to pay for a car. One, you might just have enough cash in your bank account and you could pay for it outright. Another model is that you could rent the car or you're leasing the car. But probably the most common is that someone pays off the car in installments. They take out a loan and then they pay back the principal on the loan, the amount that you borrow plus interest over some period of time. And so that's what we're going to focus on in this video.

What we have here are just some numbers that might go with a car purchase. The first we see here is the car price: $20,000. Now, it's worth clarifying what would have to go into this. Let's say you go to the dealer and you negotiate a price of say $20,000. It turns out that you're going to have to pay more than $20,000 because of tax, and that sales tax is going to be sales tax depending on where you live. Oftentimes, it might be as much as 10% more than that. So, if you negotiate a car price of say $20,000, all of a sudden when it's time to sign the documents, you might see $22,000.

The car price, or the amount that you're going to have to put up in order to take that car home, is going to be the price of the car plus tax. And there they might throw on some other fees there, like destination fees, etc., etc. So definitely don't just assume that whatever just the price of the car is, is what you're going to have to pay. You're going to have to pay that plus some other fees.

But let's assume that this $20,000, plus tax and fees, is going to be the total. Then you have to think about how much are you going to be able to put up versus how much are you going to have to borrow. In this scenario right over here, the purchaser has $4,000 to put towards the car. So there's $16,000 left that they are going to have to borrow. This is the loan amount.

Now, this interest rate, and we'll see in a second how the interest rate affects the payments that you would have to make, but we're going to assume a 5% interest. And that's going to change depending on your credit score, depending on what's going on with interest rates in the broader economy and the broader market.

And then last but not least, the loan term. This is how long it's going to take for you to pay down the loan. In this case, this is 36 months now, and that tends to be on the shorter end of the range that people usually do when they're trying to get a loan for a car.

But let's think about what type of payment this will result in. There are videos on KH Academy that go into the math; you could actually calculate it yourself. But lucky for us, there's also payment calculators throughout the internet, including on KH Academy, where when you do the exercises associated with this content, you will be able to have access to exactly this payment calculator right over here.

So let's just use it. It says loan amount; well, that's going to be the $16,000 right over here. $16,000—that's what we are borrowing. The interest rate is just going to be a number between zero and 100, so whatever number we put in there, that's going to be that many percent. If we say 5%, then the loan term, we could give it in years or months. 36 months is going to be three years, and we could see it immediately calculate $479.51.

It's really important to use one of these payment calculators to think about can you afford $479.51 a month. Then you're going to have to borrow $1,000; you can see that increased your monthly payment. Now, let's take that back to $16,000. We're back at $479.51.

Now let's think about the loan term. If instead of paying it in three years, I pay it in four years, well that does reduce my monthly payment. Now you have to be very careful here because remember you're paying for a whole other year. And that whole time, not only are you paying down the loan, but you're paying interest for another year. So more of that money is going to go to interest.

Now you might say, let's go to five years, and you could go to six years. The longer you go, your payment is going to go down, but you have to keep in mind that you're paying that fairly large amount for a longer and longer time period. And usually, the longer the loan term, the interest rate goes up as well because the bank or whoever is lending to you is taking on more risk.

But let's go back; what's typical is usually 3 to 5 years. Let's say at four years right over here. But let's see how the interest rate affects it. Let's say instead of a 5% interest rate, you had an 8% interest rate. Well, now all of a sudden you're paying a good bit more. If you had to go to a 10% interest rate, now over four years you're only doing a little bit better than when you had a 5% interest rate, paying over three years.

So as you can see, all of these variables really matter. But the key point here is to use these types of calculators, these payment calculators, to figure out what you can afford. I recommend not taking out something that's going to be more than four or five years. Sometimes people get into a scenario where they actually owe more on their car than their car is worth because their car has depreciated so much.

In general, psychologically it's always nice to pay something off sooner than later. By doing that, you're likely to get a lower interest rate, and you're going to have to pay less in total interest. Then you're going to free up more cash sooner because you've paid it off sooner.