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Working with Basic Financial Calculations

This chapter is from the book

In this chapter

  • Calculating Loan Payments

  • Calculating Principal Payments

  • Working with Future Value

  • Using the Present Value Function

  • Calculating Interest Rate

As you learned in the previous chapter, Excel has a library of built-in functions for performing a wide variety of calculations. Several dozen of these functions deal with financial matters, and while most of them are highly specialized, there are several that deal with basic calculations the average Excel user might find useful. In this chapter I will explain what these functions do and how to use them. Along the way I will explain some basic financial terms and concepts.

Calculating Loan Payments

Few people can make it though life without taking out one or more loans. By extending payments over a period of time, a loan enables you to buy something now that otherwise you would have to save for over a long time. Big ticket items, such as a car or house, are perhaps the most common uses of loans.

When evaluating a loan, most people ask, "Can I afford the payments?" The overall price is not the issue, some people think, but whether the monthly payment will fit into the budget. The amount of the monthly payment depends on the three parameters of any loan:

  • The principal, or amount you are borrowing

  • The interest rate

  • The term, or length of the loan

Larger principal, higher interest rate, and shorter term all lead to higher payments.

You should be aware that judging a purchase solely on the monthly payments is not a good idea. Lower monthly payments might seem attractive now, but all other things being equal, they mean you will pay more over the long run for whatever you are buying. Keeping this caveat in mind, you can make decisions based on Excel’s loan-related calculations.

You can use Excel’s PMT function to calculate the payment on a loan. This function is applicable only to loans where the payment amount is fixed for the length of the loan. Most mortgages and auto loans fall into this category. It is not applicable for credit card payments.

The PMT function uses the following syntax:

The first three arguments are required. They are

  • rate is the interest rate for the loan.

  • nper is the term of the loan expressed as the number of payment periods.

  • prin is the principal, the amount you are borrowing.

When using PMT in a worksheet, it is essential that rate and nper use the same time units. What does this mean? Because most loans have monthly payments, you would have to express nper in months. For example, a five-year loan would have a term of 5 x 12 or 60 months. However, interest rate is always expressed by banks and loan companies as an annual rate. For the function to work correctly, rate must be per period, in this case the rate per month. This is easily obtained by dividing the annual interest rate by 12.

The last two arguments are optional (as indicated by the brackets in the formula):

  • fv is the future value of the loan, or the amount still owed when you have completed payments. Because loans are almost always paid off in full, you will use 0 for this argument or omit it, in which case Excel assumes 0.

  • type indicates when payments are made. Use a value if 1 if payments are made at the start of each period. Use a value of 0, or omit the argument, if the payment is made at the end of each period (the case for most loans).

In most situations you omit both of these optional arguments.

Let’s create a simple loan calculator using the PMT function. Start with a blank worksheet and then follow these steps:

  1. Put the labels Amount of loan, Annual rate, Term in years, and Monthly payment in cells B2 through B5, in order.

  2. Format cells C2 and C5 as currency with two decimal places.

  3. Format cell C3 as percentage with two decimal places.

  4. Enter the following formula in cell C5: =PMT(C3/12,C4*12,C2).

Note how in this formula we have done two things to make the result come out right:

  • Divided the annual interest rate (in cell C3) by 12 to get the rate per month.

  • Multiplied the yearly term (in cell C4) by 12 to get the term in months.

When you first enter the formula the cell displays #DIV/0!, which is Excel’s way of telling you an error occurred in the cell. An error occurs because the input cells are blank and the function cannot calculate. Go ahead and enter data in the three input cells and you’ll see a result displayed, as shown in Figure 3.1. Note that the payment amount is a negative value. This is in keeping with the way Excel handles cash flow, as was explained in Chapter 2, "Using Excel to Work with Money." Because a loan payment is money going out, it is expressed as a negative value.

Figure 3.1

Figure 3.1 Using the PMT function to calculate loan payments.

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