What's the Difference Between Amortization and Depreciation?
One relates to your car's value, whereas the other relates to your loan payments—but which is which?
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Article QuickTakes:
Amortization and depreciation are important concepts for understanding how your auto loan works and how your car's value changes over time. Amortization is how the amount of a monthly loan payment that goes toward your principal changes over time, whereas depreciation describes your car's loss in value due to normal use and other factors.
What's the Difference Between Amortization and Depreciation?
Both depreciation and amortization can affect your personal finances as a car owner, but they do so in different ways.
Amortization
When you borrow money to buy a car and make timely payments, the lender may amortize your payments which will change how much you pay toward the principal debt on the loan. Each monthly payment is the same, but the portion of your payment that goes toward interest vs. principal changes each month.
Toward the beginning of the loan term, most of your monthly payment goes toward interest. The closer you get to the end of your loan term, the more of your monthly payment goes toward principal.
Depreciation
With rare exceptions, a car's value is highest when it's brand new. Depreciation hits cars especially hard right at the start, with the majority losing 20% of their value within the first year. In years two through five, the car might depreciate by another 15% each year.
Every car depreciates at a different rate. Many factors are at play: market conditions, how many miles you put on the car, and how well you take care of it. Gas mileage and the make and model's reputation for safety and reliability also matter. A popular, reliable, and well-maintained car driven lightly will tend to depreciate more slowly than a less reliable, poorly maintained car that's driven heavily.
What Factors Affect Car Loan Amortization?
How much you borrow (the loan principal), your interest rate, and your loan term all affect car loan amortization.
Let's say you borrow $20,000 at 6% for 60 months. Your monthly payment will always be $387. However, your first monthly payment will apply $287 toward principal and $100 toward interest, while your last monthly payment will apply about $385 toward principal, and the remaining $2 or so toward interest.
What if you borrow $20,000 at 6% for 36 months? Your first monthly payment of $608 will apply $508 to principal and $100 to interest. Your last monthly payment will apply about $605 toward principal, and the remaining $3 toward interest.
The amortization schedule for the shorter loan term allocates more toward principal and less toward interest. The monthly payments are roughly 50% higher, but you pay about $1,215 less interest overall.
How Depreciation Affects Car Loans
If your car depreciates faster than you pay down your principal, you can end up owing more than your car is worth. Being underwater or having negative equity can be a problem if you want to sell your car or if your car is seriously damaged.
Depreciation vs. Amortization
Suppose you take out a simple interest loan for $30,000 for 84 months at 7% interest to buy a new car. After two years of making payments exactly on time, you will still owe approximately $22,866. Because of how car loans amortize, you pay more interest at the beginning of the loan, which means your principal balance is still relatively high. If you regularly make early monthly payments on a simple interest loan, less interest will accrue and more of your payment will apply to the principle. This could help reduce the amount of interest you owe over the life of your loan.
You've driven far more miles than the annual average, and while you love your car, it doesn't have the best reputation. Your car has depreciated by 25% in the first year and 15% in the second year. It's now worth $19,125, and you want to sell it.
Selling Your Car
You can try listing your car for $23,000 to help you pay off your loan, but know that it's unlikely that someone will give you that much. Buyers have done their research and expect to pay what the car is worth. You end up accepting $19,000. To pay off your loan, you have to contribute $3,547 from your own savings.
If you can't or don't want to pay money to get out of your loan, you might keep the car until your loan balance is closer to your car's value. Another option might be to trade in your vehicle and add the difference to a new loan for another car.
Totaling Your Car
What if an accident totals your car after two years? Your insurance company will only pay you what your car was worth before the accident, or what you would spend for a comparable car on the open market. That may not be enough to pay off the loan, and you won't have a car to drive either.
Some borrowers purchase GAP insurance to protect against this risk. However, this insurance only covers the gap between the car's value and the loan balance when there's an accident, not when you want to sell.
Final Considerations
Understanding auto loan amortization, vehicle depreciation, and how they interact can help you make a decision you're comfortable with the next time you finance a car.
If your budget is tight, you may want to purchase a reliable used vehicle that will depreciate slowly and finance it with a shorter loan term. If your budget is more flexible, you might choose the car you like best—even if it's less practical.
