It’s one of those rare quiet days today at the office. Seems like the perfect time to talk about car loans and simple interest. Armed with this knowledge, you can be a far more informed customer when you speak to your lender.
You probably already know that when you borrow money from a bank or finance company, you need to compensate them for the privilege. The bank is viewing an investment in financing or refinancing your car strictly through a business lens: they lend you the money for your car purchase, and you repay the loan plus interest in monthly installments over a set time frame. For your lender, a loan to you is an opportunity to earn income in the form of interest payments. For you, the benefit lies in owning a car you can rely on for both transportation and enjoyment over the next several years.
In making a loan to you, how does the lender decide what to charge you for the use of its funds? Most auto loans use a simple interest formula to calculate your payment schedule. Let’s say you borrow $20,000 to refinance your car over a 48-month period at five percent interest. You can use an online “amortization calculator,” such as the one at www.amortization-calc.com, to get an idea of what your monthly payments would be—in this case, $460.59.
The Process of Amortization
Here’s where the concept of amortization factors in. When you make your first month’s payment of $460.59, you are paying five percent on the entire $20,000 you borrowed. As you make payments, however, a portion will be applied to interest and a portion to pay down principal. This ratio of interest/principal will vary as your loan is gradually paid off over the 48-month period. This is because as you make payments, your principal will decline by a bit each month so you will owe less in interest on the remaining amount.
Using the example above, www.amortization-calc.com shows the first and last two months of payments (see chart below). Your first month’s payment of $460.59 will include a higher component of interest than any other month. While the first month’s payment shows $83 applied to interest and $377 applied to principal, by the final payment of $460.59 four years later, only $2.00 is applied to interest and $459 is applied to principal. This is called an amortizing loan, based on simple interest.
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Though the concept of amortization may sound complicated, don’t be concerned. You still are paying the same $460.59 each month. Your lender will do the allocation between interest and principal for you and apply your payments properly each account. And once your loan is paid off, the car is yours, free and clear!