An individual takes out a car loan when he or she cannot afford to make an upfront payment for the whole price of the car. Car loan amortization refers to the process of making several regular repayments on the amount he or she owes over a specified period of time. As the borrower makes each payment, the amount of outstanding loan decreases until the debt is finally totally repaid at the end of the car loan amortization period.
Car loan amortization requires the borrower to repay the debt in several installments. The amount of each installment depends on the interest rate, loan period and loan amount. If the borrower has these pieces of information, he or she can calculate the repayment amount using a formula.
In the formula, "P" represents the principal or loan amount, "r" represents annual interest rate and "m" stands for loan period in months. The amount of each repayment can be calculated using the following formula: [P (r / 12)] / [1 - (1 + r / 12)^{-m}]. The annual interest rate is divided by 12 to turn it into a monthly interest rate because the borrower makes monthly repayments.
For example, assume that a car buyer makes a down payment of $5,000 US Dollars (USD) on a $20,000 USD car. The three-year loan has an interest rate of 7 percent. The principal would amount to $15,000 USD ($20,000 USD - $5,000 USD), the annual interest rate would be 0.07 and the loan period would be 36 months. Plugging the numbers into the formula, the calculation becomes as follows: [15,000 (0.07 / 12)] / [1 - (1 + 0.07 / 12)^{-36}]. Each monthly repayment for this car loan would amount to $463.16.
Each repayment has a portion that goes into interest and a portion that goes into reducing the principal debt. In the example, the borrower's first installment would pay for an interest of $87.50 USD ($15,000 USD X 0.07 / 12) and principal repayment of $375.66 USD ($463.16 USD - $87.50 USD), leaving a car loan balance of $14,624.34 USD ($15,000 USD - $375.66 USD). His or her second installment would pay for an interest of $85.31 USD ($14,624.34 USD X 0.07 / 12) and principal repayment of $377.85 USD ($463.16 USD - $85.31 USD), leaving a car loan balance of $14,246.49 USD ($14,624.34 USD - $377.85 USD). Similar calculations continue until the whole debt is repaid.
A car loan amortization table shows the period of time, the amount of each repayment, the portion of each repayment that goes into interest, the portion that goes into reducing the debt amount and the outstanding balance after each repayment until the whole debt is paid off. A car loan amortization table clearly shows that the outstanding balance decreases after every repayment, decreasing the portion that goes into paying interest and increasing the portion that goes into paying off the loan. This makes amortization a cheaper way to repay a car loan compared to simple interest, where the portion that goes into interest remains the same for every installment.