Are Car Loans Amortized Like Mortgages?
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Amortization refers to how you pay off your loan, and can vary between a car loan vs. a mortgage.
New cars and homes are two of the biggest purchases you might make in your lifetime, and paying them off can be a long personal finance journey. If you’re lucky enough to come into some extra money, paying off your loan sooner can be a great option. You’ll be that much closer to owning your car or your home free and clear, and you’ll save a lot of money — usually.
The catch is that not all payoff plans are the same. The way that you pay off your auto loan might not be the same as for your mortgage, and that can have real consequences for whether you’ll save money by paying off your loan early or not. We’ll break it down and help you figure out what type of auto loan you have, and whether you’ll save money by paying it off early.
Car Loan vs. Mortgage Amortization
Let’s compare.
How are mortgages paid off?
Most mortgages are paid off in amortizing loans (more on how that works below). Since mortgages are such a large loan, it can be especially scary for most homeowners to see how much money is going towards interest when you first start repayment on the loan. However, it’s definitely more favorable to you than a precomputed interest mortgage would be, like how some auto loans are paid off.
Paying more towards your home loan at any time can help, but that’s especially true near the start of your mortgage. Of course, most people aren’t able to do that right out of the gate since they likely exhausted their savings for the down payment. But if you can, it can be a good option to significantly reduce the amount of interest you pay over the life of your loan.
How are car loans paid off?
Car loans, on the other hand, are a bit more variable. They can be either simple interest amortizing loans or precomputed interest loans. The only way you’ll know is by asking the lender and reading your loan documents before you sign on the dotted line.
Simple Interest amortized car loans tend to be more common at banks, credit unions, and other lenders. Precomputed interest loans, on the other hand, tend to be more common with buy-here-pay-here lenders. This is unfortunate because borrowers who visit these lenders may not have stellar credit scores to qualify for good loans, and are often the least able to pay for expensive, lender-friendly loans.
If you’ve already taken out a precomputed interest loan, the only way to get out is to refinance your auto loan. But remember, you’ll still be paying the interest on that entire loan whether you pay it off early by refinancing or not, so it might not actually save you any money in the long run. In that case, your money might be better used going towards something else, such as building up an emergency fund or saving for retirement.
What Is Amortization?
Most loans are paid off through a process called “amortization,” and if you know how it works, you can use it to your advantage.
The idea is pretty simple: Each month, you make a payment on that loan. That payment is then split up into two parts: One bit goes to your lender as interest, and the other bit goes towards paying down the balance of the loan (also known as “principal”).
Your monthly payment will stay the same, but how it’s divvied up between interest and principal will change each month. Each month, your interest portion is recalculated based on how much you have left to pay off on the loan. You’ll generally pay more interest at the start of your loan and less towards the end. You’ll save money on interest costs any time you pay down the balance of your loan, but especially closer to when you start paying it back.
Mortgages and car loans usually (but not always) have fixed interest rates that stay the same over the life of the loan, so the calculation is the same from month to month. This also makes it easy, because your payment amount won’t change either.
To figure out how much of your monthly payment will be going towards principal in any given month, you can use the simple loan amortization formula below:
\[Principal Payment = Total Monthly Payment-Outstanding Loan Balance ( { {Interest Rate} \over 12 months})\]
Some loans, like adjustable-rate mortgages (ARMs) have rates that change every so often. With a 5/1 ARM, for example, the rates will stay the same for the first five years and then change once a year, every year, after that. With each new rate adjustment, you’ll get a new amortization schedule and a new monthly payment amount to make sure you stay on track to pay the loan off according to schedule.
How amortization changes over time
If you noticed above, in the second month, the amount of money going towards principal and interest changes. That’s because as your principal balance goes down each month, your interest payments will get smaller and smaller, until you’ve paid the loan off.
In fact, you might pay even more towards interest than towards principal when you first start paying off the loan. That can be super frustrating since it seems like you’re not making any progress on paying off your loan. But over time, that principal payment will get larger and larger, and your balance will really start to decrease more noticeably each month towards the latter half.
What if I make extra payments?
The above explanation is a neat point if you’re an accounting nerd, but for most of us, it doesn’t really matter — until you’re looking to make extra payments on your loan.
When you send in an extra payment to your lender, check in advance that they’ll use that money to pay down the remaining principal on your loan. If you do this, your remaining balance will go down faster than otherwise planned.
But here’s the real beauty: since your loan balance is now even lower, and since your interest payments are based on your balance, you’ll pay less in interest for the rest of the time you have that loan. The more you pay off early, the more money you’ll save, and that’s the power of an amortizing loan.
Early Payoff Auto Loan Calculator
What Is Precomputed Interest?
Look closely at your loan documents before you sign, and ask: is this a simple interest amortizing loan, or does it use precomputed interest?
The way a precomputed interest loan works is much simpler on paper. Your lender will calculate up-front how much loan interest you’ll pay until the total amount is paid off. Then, they’ll tack that total interest onto the loan amount you’re borrowing to see how much total you’ll pay back over the life of the loan. They’ll then divide this number by the total number of loan payments you’re scheduled to make.
For example, if you’re borrowing $10,000 and paying it back with a loan term of three years, you might owe $2,000 in interest over the course of that loan. Your lender will tally up the interest and the amount you’re borrowing to get $12,000, then divide it by 36 months to get a monthly payment amount of $332.
In this way, your interest portion is pre-baked into each car loan payment rather than being recalculated fresh each month. Your loan balance will decrease at a steady rate with each monthly payment, rather than slowly at first with a steeper decline later.
Consequences of a loan with precomputed interest
A simpler way to calculate your payments sounds good, but it has a glaring problem: You won’t save any money by paying off the loan early. Whether you pay the loan off on schedule or early, you’ll pay the same amount of interest. It’s a system that favors the lender, and not you.
If you pay your loan off according to schedule there’s really no difference between a simple interest amortizing loan and a precomputed interest loan. But if you think you might want to pay it off early, then choosing a loan with precomputed interest can really hurt you later. The only benefit you’ll get from paying it off early is being free of the loan sooner. You won’t save any money by doing it, though.
Amortization Auto Loans Can Save You Money
You might not have any immediate plans to pay off your car loan early (or, maybe you do and that’s great too). Either way, an amortizing car loan is a better choice because then at least you’ll always have the option to save money if you pay off your loan sooner. After all, you shouldn’t have to pay interest on money that you’ve already paid back to your lender.
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