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Car Loan Amortization: What Is It and How Does It Work?

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When you take out a car loan, the lender will tell you what monthly amount you have to pay and for how long. However, what percentage of it goes towards the principal and interest respectively? The car loan amortization schedule tells you exactly that. 

Unless they’re swimming with cash and have lots to spare, most people cannot afford to buy a car outright. Therefore, car loans are the most sensible option to take – which allows them the convenience of driving the car while paying off the loan over a period of time. However, on top of the principal, you will also have to pay interest charges, which is how the lender makes money off the loan.¬†¬†¬†

How does the lender decide how much you have to pay and whether it should go towards repaying the principal or the interest? The car loan amortization schedule helps you understand that. 

Car loan amortization is the process of dividing up the total borrowed loan amount into equal monthly installments which can be paid over a period of time. The monthly payments are equal throughout the loan period, but a larger part of the installments goes towards the interest charges early on, while more of the principal gets repaid in the later part of the loan.

What is car loan amortization

How does car loan amortization work?

A car loan amortization schedule shows you how your monthly payment is split up between the interest and the principal over the life of the loan. You will be able to see how each payment is applied to repay the loan principal and the loan interest respectively throughout the life of the loan. It also shows the reducing balance until it finally hits zero and the loan is paid off.

what is car loan amortization

How to calculate you car loan amortization

The equal amortized monthly payment is calculated using the formula below:

A=P \frac {i(1+i)^n}{(1+i)^n-1}

where

  • P = the principal amount
  • i = the interest rate per month, which equals the annual interest rate divided by 12
  • n = the total number of months
  • A = monthly payment to be paid

 

Factors that affect your car loan amortization schedule

The actual amortized amount that you will need to pay every month depends on the following factors:

Principal

The principal is the total amount you borrow to purchase the vehicle. As the loan is repaid every month, it can also indicate the remaining portion that is left to be paid off.

Interest charge/APR

The interest charges indicate the cost of borrowing from the lender.

Down payment

The more you make as a downpayment, the lesser you will have to pay in amortized installments. A larger down payment can also help you avoid going “upside down” on your car loan. As a rule of thumb, always make a 20% down payment on your car purchase.

Loan term

According to the 20/4/10 rule, an optimal loan term is between 4-5 years. Try to avoid signing on for 72 or 84-month loan terms, as this increases the  interest charges accrued on the loan.

What is a car loan amortization schedule?

A car loan amortization schedule shows you how much of your monthly loan payment goes towards repaying the interest charges and the principal respectively. Let’s illustrate with an example.

Let’s suppose that you are planning to buy a car worth $40,000 in January. You will make a downpayment of $5000, and borrow the remaining $35,000 from a lender at a 10% interest rate and for a five-year term.

Here’s what your car loan amortization schedule will look like:

YearInterest PaidPrincipal RepaidEnding Balance
First Year$3,244$5,679$29,321
Second Year$2,650$6,274$23,047
Third Year$1,993$6,931$16,115
Fourth Year$1,267$7,657$8,459
Fifth Year$465$8,459$0

As you can see, the monthly payment every month (interest+principal) is the same – $8923 – but different portions of it get put into the interest and principal components. In the first and second years, a larger proportional amount goes towards repaying interest, and it progressively decreases towards the fourth and fifth year of the loan.

Are all car loans amortized?

It is easier for borrowers to plan their finances if they have equal monthly payments. Therefore, all car loans are amortized. Such loans are common for most mortgages, personal loans, and auto loans.

Can I pay off an amortized car loan early?

Yes, you can pay off an amortized car loan early by either making a lump sum payment or making extra payments every month. If you cannot afford to pay the full amount, start by paying principal-only extra payments that reduce the pending balance every month and reduce the amount of interest accrued.

However, it’s best to check with your lender if there are any prepayment penalties for closing an amortized loan early.

Can I be penalized for paying off my amortized car loan early?

Some lenders can charge you up to 2% of the remaining loan balance as a prepayment penalty if you make a lump sum repayment. If that cost seems a bit too steep, you can ask the lender if you can make bi-weekly payments or extra principal-only payments every month.

Frequently Asked Questions (FAQ)

How do you amortize a car loan?

You can amortize a car loan by first deciding the duration of repayment, and dividing the total amount into equal installments spread out over the period.

What is a car loan amortization schedule?

The amortization schedule shows what portion of the monthly installment is used to repay the interest, and how much is used to repay the principal. Initially, a larger part will go towards repaying the interest charges.

Are payments on car loans amortized?

Yes, car loan payments are amortized – just like mortgages and personal loans. This makes it easier for borrowers to chart out their finances and set a time horizon for paying off the loan.
What is car loan amortization

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