How Are Auto Loans Amortized?

Introduction to Auto Loan Amortization

What is Amortization?

A loan that amortizes means that the principal is reduced over time and requires monthly (or regular) payments. Your monthly payments are applied to the loan's principal and your interest charges that accrue. Most car loans use a simple interest formula. This means that your interest charges accrue daily based on the balance of your principal. The less you owe, the less you pay in interest charges.

The benefit of a simple interest formula is that with each on-time payment, you’re reducing your interest charges because you’re lowering your principal balance. This also means you're charged less interest each time your payment rolls around.

Importance For Car Buyers

To see how much interest you’re charged per payment, you can look up an amortization schedule and enter your auto loan terms. Here’s a quick example:

Auto loan terms:

$20,000 car loan / 60-month loan term / 10% interest rate / $424.94 monthly payment

• First payment of $424.94:
  • Interest $167 / Principal $258 = Balance $19,742

• Second payment $424.94:
  • Interest $165 / Principal $260 = Balance $19,481

• Third payment $424.94:
  • Interest $162 / Principal $263 = Balance $19,219

As you can see, with each monthly payment, you lower how much you pay in interest charges. Since there’s less interest accrued, more of your monthly payment is applied to your principal every month.

How Amortization Works

As previously mentioned, each amortized payment consists of interest plus principal. The more payments you make throughout your loan, the less you'll pay in interest. Instead, more of your monthly payment will be going toward the principal, which is the actual amount of money you borrowed to pay for your vehicle.

Factors Affecting Amortization

The three main components of an amortized auto loan are the principal, interest rate, and the term. The principal aspect is pretty straightforward, as the higher the amount is that you're borrowing, the more you'll have to pay off. Putting more money as a down payment will bring the principal and your monthly payment down, but you'll need to have the cash on hand to do so.

When it comes to interest rates, a higher rate means that you'll be paying more interest initially and throughout the loan. Your payments will be lower and go more toward the principal with a lower interest rate.

Longer loan terms mean lower monthly payments, but you'll end up paying more in interest over time. Shorter loans will have higher monthly payments, but you'll end up being on the hook for less interest.

Understanding Amortization Schedules

What is an Amortization Schedule?

An amortization schedule is a breakdown of your schedule of payments throughout your loan. It tells you how long you'll be making payments, as well as how much is going toward interest and how much toward principal.

How to Read and Use One

Each column in the schedule tells you about a different aspect of your loan. Your payment number tells you which month you're currently paying. The payment section tells you how much you owe each month, which should remain constant throughout your loan. The interest and principal sections tell you how much of your payment is going to interest or principal each month. Lastly, the remaining balance column tells you how much of the loan you still owe.

Benefits of Tracking Your Amortization

Tracking your amortization is useful because it allows you to see how much you owe at any point during the loan. It can also help you with making early payments or generally managing your budget.

Using Auto Loan Calculators

How it Works

Auto loan calculators can be a great way of managing your budget or comparing loan offers. They determine your monthly payment and total balance based on the information you provide.

Key Inputs for Tracking Estimates

You'll need to provide the price of the car, down payment, interest rate, and the loan term to see your calculation. Some calculators also allow you to add taxes and fees for a more accurate estimate.

Common Myths About Amortization

It might seem unnecessary to learn how loan amortization works, but having an understanding of the different components of your loan can help you budget, as well as give you leverage when negotiating. Another common misconception is that your payments go equally toward interest and principal. Earlier payments go more toward interest, which means paying more early will save you money in the long run.

Amortization vs. Depreciation

Amortization refers to repaying the money you borrowed to pay for your car. Depreciation, on the other hand, occurs when your car declines in value over time, which is independent of your loan. However, it's worth having an understanding of both so you don't end up upside down on your loan, which means you owe more than the car is worth.

FAQs

How Does My Credit Score Affect Loan Amortization?

While you may have some say in your loan terms, your credit score is a major player in qualifying for vehicle financing and determining your interest rate. With a low credit score, you’re more likely to qualify for a higher interest rate. If this is the case, then it’s typically more beneficial for you to choose a shorter loan term and/or a more affordable vehicle.

Opting for an expensive vehicle with a long loan term and a high interest rate puts you at risk for negative equity. Negative equity is when you owe more on the car than it’s worth. A higher interest rate can mean more of your monthly payment is applied to interest each month, and less to your principal, which can make it hard to lower your loan balance quickly.

If you’re a bad credit borrower and you’re concerned about paying excessive interest charges, it’s wise to choose a used vehicle. They’re usually more affordable, and you’re more likely to qualify for a loan on a lower sticker price.

If you have poor credit, a down payment requirement is customary. A good savings goal is at least $1,000 or 10% of the vehicle’s selling price. Most subprime lenders require at least that, and you can always put more down. The more cash you bring to the table, the fewer interest charges accrue over the course of your loan.

How Can I Calculate My Monthly Auto Loan Payment?

You'll need to know how much the car costs, how much you plan on putting down, the interest rate, and the term of the loan. Again, using a calculator that accounts for taxes and fees will give you the most accurate picture of your estimated payment.

Why is it Important to Understand My Amortization Schedule?

It can be useful to see how much of your payment goes toward interest and how much goes toward principal. Opting to make extra payments earlier in the term can get your car paid off faster than if you opted to make more payments toward the end of your loan. Knowing when and where your money is going can also be useful for managing your budget and ensuring you don't get upside down on your loan.