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What is Loan “Amortization” and how does it work?

last updated December 23, 2013 by

When you go into a dealership, some confusing terms get thrown around regarding your financing arrangement.  Your loan has both a principle and an interest rate, and the two are combined to produce something called an amortization schedule.  Amortization is the process of paying off a loan through pre-arranged payments over time, with the payments varying in their composition as the borrower pays of their principle and interest.

How are Payments Calculated?

When you submit a payment on an auto loan, a portion of your principle is being paid off.  If it weren’t for amortization, the amount that you pay on every subsequent payment would go down, since the principle of the loan is decreasing over time.  Amortization spreads the total interest that you owe on the loan across the entire life of the loan, ensuring that much of the interest is frontloaded to the earlier payments of the loan.

In a typical auto loan, you might start out paying mostly the interest of your loan, with the payments gradually shifting to mostly principle towards the end of the loan’s life.  For example, your first payment of $1,000 might be $800 for interest and $200 for the loan’s principle, with the composition of the loan reversed in the last year of the loan.

Why are Loans Amortized?

An amortization schedule benefits lenders because it ensures that they will get their profit on every loan earlier in the loan’s lifecycle, just in case the borrower chooses to pay the loan off early or in case the borrower becomes delinquent.  For the borrower, this type of loan schedule provides consistency because it allows the bank to offer the same payments throughout the life of the loan, rather than huge payments at the beginning of the loan that gradually are reduced throughout the loan’s term.

There are a number of different ways that amortization schedules can be created, with different payment methodologies such as the balloon payment or the linear amortization, but auto loans are usually fairly straightforward, with a gradually shifting percentage of the loan going towards the principle as you get closer to paying the loan off.

What does it mean for you?

The amortization of loans means a couple things for you as a borrower.  For one, you equity in your car will increase more slowly at the beginning of your loan than at the end of your loan, so if you sell your car early in the loan you will receive less for the car as a proportion of the payments that you made. Secondly, make sure that you receive a copy of your amortization schedule from your lender so there are no misunderstandings if you choose to refinance or sell your car while you are still making loan payments.  Every lender is required to provide this document, so be sure that you read over it carefully.