Consider a $20,000 car loan over five years at 8% APR. Assume an option where the car loan offers 0% financing for the first two years of the loan or 8% financing over five years
What are the payment choices to ensure that no interest on the loan is paid? Does this imply that money is "free"? Explain.
What will be an ideal response?
Answer: There are two methods to consider. First, you can make 24 equal payments of = $833.33. This will pay off all of the loan before interest is charged. Second, you can make the regular 8% APR payments for two years and then pay off the balance with what is called a balloon payment. The PVIFA factor for 5 × 12 = 60 periods and a periodic interest rate of = 0.66667 is 49.31843. The monthly annuity payment is: PMT = = = $405.53. The total monthly payments for two years would be 24 × $405.53 = $9,732.67. Therefore, your balloon payment at the end of two years would be $20,000.00 - $9,732.67 = $10,267.33. Do the two methods imply that money is "free"? The answer is yes only if you are willing to make the loan period last just two years and can either (i) increase your monthly payments to $833.33 or (ii) pay off the balloon balance of $10,267.33 at the end of the second year following 24 equal payments of $405.53. For many people, these two options may not be feasible. For example, many people may find $833.33 a month for a car loan too much for their budget even if for only two years, and it may be even more difficult to come up with a balloon payment of $10,267.33 after the two-year period.
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