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What’s the difference between car loans and mortgages?

By   |  Posted in Ask The Expert

Q: Are car loan payments calculated differently than mortgage payments?

A: Monthly payments for some auto loans may not be calculated the same way a mortgage loan is.

Mortgage payments

For mortgages, the process of amortization is essentially a compounding method. A good way to think about mortgage amortization is that you don't have one single loan, but rather individual loans with terms of 360 months, then one for 359 months, then one for 358 months and so on, all strung together.

Each month sees a payment calculated with a smaller loan balance over the new shorter term, and while the total of the payment remains the same, the amount of interest you pay in a given month decreases while the amount of principal you pay increases.

This is a process known as "amortization." To determine your monthly mortgage payment over the life of your loan, be sure to check out our mortgage calculator.

Car loans

On the other hand, installment loans--like a car loan--can either be:

  1. "Simple interest add-on" or
  2. "Simple interest amortizing"

Simple interest add-on loans: These are actually written as a single loan; all of the interest that will be due is calculated up front, added to the total of the loan as a finance charge, then that sum is divided over the number of months in the term to arrive at your monthly payment. Each payment consists of exactly the same amount of principal and interest, and as such, there's no savings to be had from prepaying these kinds of loans early.

Simple interest amortizing loans: These work like a mortgage, with a declining loan balance and declining term producing a constant monthly payment with changing compositions of principal and interest. Prepaying these can save you some money.

A loan to avoid

There can also still be loans based upon a thing called the "Rule of 78."

These are simple interest add-on loans with a twist; they are structured to have you pay the interest due on the loan first, then once that's done, your payments will cover the principal.

These should be avoided, since you end up "renting" money during the early years of the loan while your principal doesn't decline. If you should hold the loan to term, there is no difference in total cost when compared to a standard simple interest add-on loan, but if you should need to pay the loan off early, you'll find that you'll still owe most -- if not all -- of the original loan you took despite having made payments for some period of time.

Loan calculator

Depending upon your kind of loan, you'll be able to use a standard amortization calculator... or not. Check your loan contract for details; if it is a "simple interest add-on" type, do a Google search for "simple interest calculator" and you should be able to find what you need.

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