What Is Auto Loan Amortization?
If you are shopping for a new or used vehicle, a term you may have encountered when applying for a loan is auto loan amortization. Although it may sound complex, auto loan amortization is very simple.
Understanding how auto loan amortization works can help you determine how much interest you will pay for the vehicle you are buying. It can also help you make important loan decisions.
Keep reading to learn more about auto loan amortization.
Auto Loan Amortization Explained
When you first see the term “auto loan amortization,” you may worry about understanding such a complicated concept. Never fear. Auto loan amortization is simply industry language for the process of repaying a vehicle loan over time. It refers to how much of your payments go toward the principal and interest.
When a loan is amortized, the amount of your monthly payment that goes toward the principal and interest changes with each payment. The amount you pay each month is the same, but the money is distributed differently.
When you start making payments on a new loan, the amount of your payment that goes toward the interest will be much higher than when you are nearing the end of the loan. With each payment you make, the principal decreases. As the amount you need to repay goes down, you will progressively pay less interest.
Factors that Influence Auto Loan Amortization
There are several components to an auto loan amortization. They can influence how much you pay for the money you borrow and how long your loan will be.
The principal is the amount of money you borrow. If you finance a new $40,000 car with no down payment, for example, $40,000 is the principal of the loan.
Interest is the money you pay your lender for the money you borrow. The interest rate determines how much interest you will pay. The lower the interest rate, the less your borrowing costs will be.
Most auto loans have fixed interest rates, which means the rate you will pay is locked in when the loan is created and will not change over time.
Your credit score is an important factor in determining the interest rate you receive. Since your credit score is a good indication of how well you handled your debts in the past, those with high credit scores are usually awarded the best possible rates.
If your credit score needs improving, taking the time to rebuild your score before buying a new vehicle may help you save on interest. Making sure all of your payments are made on time and paying off some of your existing debt are two things that may improve your score.
The down payment is the amount of money you pay upfront. If you pay $5,000 for a $30,000 vehicle, for example, and finance the rest, $5,000 is the down payment. The higher the down payment you make on your auto loan, the less you will have to pay in interest.
The loan term refers to the length of your loan. The average loan term is currently 63 months, although longer terms of 72 and 84 months are becoming more common as vehicle prices increase.
The longer your loan term, the more you will have to pay in interest. The main benefit of going with a longer loan term is that it can help you lower your monthly payments.
Auto Loan Amortization Example
A practical example of loan amortization can help you understand how it works.
Let's assume that you finance the purchase of a new $40,000 car with a $10,000 down payment. To keep your payments low, you select a 60-month loan with a 4% interest rate. With this arrangement, you will have to repay the principal of $30,000, and the total interest comes to $3,149.74. Your monthly payments are $552.50.
When you start making payments on your new loan, you discover that $100 of your first $552.50 payment goes toward the interest while the remainder goes toward the principal. With each subsequent payment, the amount that goes toward the interest goes down a little, while the amount that goes toward the principal increases.
In the first year of repaying your loan, you will pay a total of $1,099 in interest and $5,531 will go toward repaying the principal.
What Is An Amortization Schedule?
One of the best ways to see how auto loan amortization works is with an amortization schedule, which shows how much interest and principal you pay with each monthly installment. Some online auto loan calculators have an amortization feature, and you can very easily create a schedule by entering your loan amount, interest rate, and other information.
Using the information from the previous example, the following is an abbreviated amortization schedule showing the first year of loan payments.
Using the same example, the following is an abbreviated amortization schedule that shows the total interest and principal paid for each year of the loan.
Auto Loan Amortization: Should You Pay Off Your Loan Early?
An important benefit of an amortization schedule is that it helps you visualize your monthly payments. This can help determine whether you should make extra payments toward the principal to pay off your loan early. Don’t forget that the earlier you repay your loan, the less you will have to pay in interest.
If you already have a vehicle loan, paying it off early could help to make room in your budget to buy a new vehicle. Check out the following article to learn about the benefits of paying off your auto loan early and how to do it.
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