Understanding Car Loan Amortization

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We’ve all been there.  You’ve had your car a couple years, and then you start getting the offers from the dealer.  “Come trade in!  Why drive an old car when you can have something newer!  Or refinance for lower payments!  It’s a special deal just for you!”  While it doesn’t feel much different than trading in last year’s clothing fashion, there’s a few things your net worth would appreciate you knowing before you make the change.

Understand Amoritization

Your first payments on a loan tend to be far more interest than you’ll pay toward the end.  It allows the lender to “hedge their bets” in a way, so that people who skip out on payments early on owe proportionally more on the vehicle than those who pay for a few years and then stop.  Using this car loan amortization calculator, if you input a 5-year loan for $20,000 at a 10% interest rate, it’ll show how the car loan requires almost half the payment to be interest at the beginning, versus basically all principle by the end.  (And the numbers are even more drastic if the interest rate is higher.)
Take this in tandem with depreciation.  We all know that a car begins to lose value the moment you drive it off the lot.  And that depreciation is a curve that goes down fastest at the beginning, then levels out as the car gets to be 10-15 years old.  The problem is that with amortization, it’s the reverse.  So your car’s value tends to go down faster than you’re paying the principle, leaving you “underwater” with your loan from the start.  This is most prominent in new cars (which depreciate faster) and longer term loans (6+ years) where the principle goes down much slower.   This really becomes an issue with refinancing a loan or trading in a car before it’s paid way down.

What Happens to the Amount When You're Underwater?

When you choose to refinance or purchase a new car before you pass that mark of owing less than the car is worth, you still roll that negative equity into the new loan.  So let’s say you owed $10,000 still on your trade in, but they’re only giving you $8000 for it.  That $2000 gets rolled into your next loan.  So you’re financing a fresh $20,000 + $2000 for a car that’s only going to be worth $18,000 when you drive it off the lot.  See what’s happening?  It becomes an ever-more-difficult cycle.

So What Can You Do to Avoid This Scenario?

  • Proactively work on improving your credit score. The better the score, the better the rate, the lower your payment, the more manageable it is.
  • Remember that refinancing a loan is basically the same thing for your finances as a trade-in. You’re starting over with a fresh 5 years, meaning new amortization and more interest up front, just as you were starting to make real progress on the principle of your old loan.  Plus, there’s usually an origination fee for the new loan which effectively acts like the negative equity (“underwaterness”) in the trade-in scenario.
  • Keep your loan at 5 years or less. If you can’t afford payments on the car at 60 months, find a cheaper car.


The real bottom line: Don’t refinance or trade-in at least until you owe less on the car than it’s worth.  Ideally, if you’re buying a fairly new vehicle, you want to drive it 10+ years so long as it’s not costing you significantly in repairs.

If you need help with any of these steps – including improving your credit score or determining whether you can afford a certain car – our Financial Service Specialists are here to help. Our Specialists can help assess your financial situation, explain the options or solutions available, and help develop an action plan unique to your needs. You can start the free and secure process online and get your personalized action plan within hours right in your inbox.* Or you can contact us to book a free financial review session: 800-355-2227.

*Please note: We respond within hours during regular business hours (Monday-Friday; 8am-5pm ET). It will take a bit longer on evenings and weekends.

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