Functions for Personal Finance
This section details how loans work and the different parts of the PMT function. Pay attention to Table 2.6, which shows the arguments (or inputs) of the PMT function.
The Fundamentals of Loans and Leases
In this section, we continue to develop the Personal Budget workbook. Notable items that are missing from the Budget Detail worksheet are the payments you might make for a car or a home. In addition, you may want to set and track a savings goal. This section demonstrates Excel functions used to calculate lease payments for a car, to calculate mortgage payments for a house, and to project future savings based on regular contributions and an average rate of return. This section also discusses the scenario capabilities of Excel once the Personal Budget workbook is complete.
One of the functions we will add to the Personal Budget workbook is the PMT function. This function calculates the payments required for a loan or a lease. However, before demonstrating this function, it is important to cover a few fundamental concepts on loans and leases.
A loan is a contractual agreement in which money is borrowed from a lender and paid back over a specific period of time. The amount of money that is borrowed from the lender is called the principal of the loan. The borrower is usually required to pay the principal of the loan plus interest. When you borrow money to buy a house, the loan is referred to as a mortgage. This is because the house being purchased also serves as collateral to ensure payment. In other words, the bank can take possession of your house if you fail to make loan payments. As shown in Table 1 Key Terms for Loans and Leases
|Collateral||Any item of value that is used to secure a loan to ensure payments to the lender|
|Down Payment||The amount of cash paid toward the purchase of a house. If you are paying 20% down, you are paying 20% of the cost of the house in cash and are borrowing the rest from a lender.|
|Interest Rate||The interest that is charged to the borrower as a cost for borrowing money|
|Mortgage||A loan where property is put up for collateral|
|Principal||The amount of money that has been borrowed|
|Residual Value||The estimated selling price of a vehicle at a future point in time|
|Terms||The amount of time you have to repay a loan|
Table 1 Key Terms for Loans and Leases
Figure 1 Example of an Amortization Table shows an example of an amortization table for a loan. A lender is required by law to provide borrowers with an amortization table when a loan contract is offered. The table in the figure shows how the payments of a loan would work if you borrowed $100,000 from a lender and agreed to pay it back over 10 years at an interest rate of 5%. You will notice that each time you make a payment, you are paying the bank an interest fee plus some of the loan principal.
Each year the amount of interest paid to the bank decreases and the amount of money used to pay off the principal increases. This is because the bank is charging you interest on the amount of principal that has not been paid. As you pay off the principal, the interest rate is applied to a lower number, which reduces your interest charges. Finally, the figure shows that the sum of the values in the Interest Payment column is $29,505. This is how much it costs you to borrow this money over 10 years. Indeed, borrowing money is not free. It is important to note that to simplify this example, the payments were calculated on an annual basis. However, most loan payments are made on a monthly basis.
Figure 1 Example of an Amortization Table
A lease is a contract in which you, the lessee, use an asset such as a car or a piece of equipment and you agree to make regular payments to the owner or the lessor. When you lease a car, the manufacturer or a leasing company retains ownership of the vehicle and you agree to make regular payments for a specific period of time. The amount of money you pay depends on the price of the car, the terms of the lease contract, and the car’s expected residual value at the end of the lease. The calculation of lease payments is similar to the calculation of loan payments.
However, when you lease a car, you pay only the value of the car that is used. For example, suppose you are leasing a car that is priced at $25,000. The lease contract is for 4 years at an interest rate of 5%. The residual value of the car is $10,000. This means the car will lose $15,000 of its value over 4 years. Another way to state this is that the car will depreciate $15,000. A lease will be structured so that you pay this $15,000 in depreciation. However, the interest charges will be based on the purchase price of $25,000. We will look at a demonstration of leasing a car as well as buying a home in the next section.
This text was adapted by Saylor Academy under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work's original creator or licensor.