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Knowing your car loan amount and interest rate can be crucial for financial planning — but understanding how you’re paying off your loan over time can be just as important.
The process of paying down your loan over time is known as amortization. With an amortizing car loan, some of your monthly payment is applied to the amount you borrowed, which is known as the principal, and some goes toward interest and any fees.
Let’s dive into how car loan amortization works and what an amortization schedule looks like. We’ll also go over factors that can affect that schedule and, in turn, how that affects the amount of interest you pay over the life of the loan.
How does car loan amortization work?
Amortization is the term used to describe the way in which a simple interest auto loan is paid off. A portion of each payment goes toward …
- Principal – The amount you’ve borrowed to cover the cost of buying your car.
- Interest charges – The cost your lender charges you to finance your car.
- Fees – You may incur certain fees over the life of your auto loan — for example, certain fees can be rolled into the Annual Percentage Rate (APR) and can increase the overall cost of the loan.
With an amortizing loan, more of your payment is applied toward interest at the start of the loan, when the principal balance is at its highest. As the principal balance diminishes, the amount paid toward interest decreases and the amount paid toward principal increases.
What is an amortization schedule?
Curious about how much of your monthly payment goes toward interest and principal? You can answer this question by creating an amortization schedule. This schedule provides a road map of how your payments will be allocated between interest and principal over the term of your car loan.
Some online calculators can help you estimate your amortization schedule. To calculate your schedule, you’ll need your loan amount, interest rate and the loan term.
What does a typical amortization schedule look like? Let’s say you made a $3,000 down payment on a $30,000 car in January 2019. To pay the balance, you took out a $27,000 car loan with a five-year loan term and 10% interest rate.
Your car loan amortization schedule would look like this.
As you can see from this example, the amount paid in interest decreases each year. As the total interest paid gets smaller, a larger portion of the payment goes toward reducing the loan’s principal.
Factors that affect your car loan amortization schedule
The following factors can have a big impact on your loan’s amortization schedule and the total amount of interest you pay.
Your down payment
You can reduce the amount of interest you pay by increasing the size of your down payment. In the previous scenario, the interest paid over the life of the loan would shrink from $7,420.21 to $6,595.74 if you increased the down payment from $3,000 to $6,000.
Your loan’s interest rate
The higher the interest rate, the more interest you’ll pay on your loan. If the interest rate on your $27,000 loan was 15% instead of 10%, the amount of interest you’d pay would increase from $7,420.21 to $11,539.69.
The length of your loan term
Increasing the length of your loan term will increase the amount of interest you pay on your auto loan. If you were to extend the loan term on your $27,000 loan from five to seven years, the total interest paid on the loan would rise from $7,420.21 to $10,651.49.Paying off your car loan early: Should you do it?
Calculating a car loan amortization schedule can give you a clear idea of how much you’re paying in interest over the course of the loan. To reduce the interest paid, consider increasing the size of your down payment or shortening the length of your loan term.
Another factor that can affect how much interest you pay on your loan is your credit. If you have lower credit scores, you may not qualify for the better interest rates on a car loan.
Taking time to rebuild your credit before taking out a new car loan could help you get a lower interest rate and pay less interest overall. If you need a car now, focus on making on-time payments for any loans you currently have. This could help boost your credit health, which might allow you to refinance your car loan down the road at a better interest rate.