Borrowing

Amortization means paying off a loan through a series of regular, usually equal, payments that each cover the interest due and reduce the principal. By the final scheduled payment, the balance reaches zero. Car loans, personal loans and fixed-rate mortgages are common examples. Credit cards and interest-only loans are not fully amortizing, because the required payment is not set to clear the balance by a fixed date.

Early payments go mostly to interest because interest is charged on the remaining balance, and the balance is largest at the start. On a $25,000 loan at 6.5% for 60 months, the first $489.15 payment includes $135.42 of interest and only $353.73 of principal. By the last year, interest is under $31 a month. Nothing about the loan is rigged; the payment stays the same while the balance it applies to shrinks.

Over a short period the two can cost about the same, because both pay for the car's depreciation plus financing. Buying usually costs less over the long run if you keep the car well past the loan payoff, since you stop making payments while it still has value. Leasing can cost less upfront each month and suits drivers who want a newer car every few years, stay under the mileage limit and return the car in good shape.

The money factor is the lease's financing rate written as a small decimal, such as 0.00250. To compare it with a loan APR, multiply by 2,400; 0.00250 works out to about 6%. Each month, the lease charges the money factor times the sum of the capitalized cost and the residual value. A lower money factor means a lower finance charge, and like a loan rate, it often depends on your credit.

The payment comes from three inputs: the amount financed, the monthly interest rate (APR divided by 12) and the number of months. A standard amortization formula sets one fixed payment that covers each month's interest and pays the balance to zero on the last payment. Early payments are mostly interest because the balance is highest then. Taxes, fees and add-ons you finance increase the amount financed, so they raise the payment even though they are not part of the car's price.

A long term is not automatically wrong, but it costs more and carries more risk. On $28,000 at 7%, 84 months costs about $7,498 in interest versus about $5,266 at 60 months. Cars also lose value quickly in the first years, and a slowly shrinking balance makes it more likely you will owe more than the car is worth for a long stretch. If you choose a long term for cash-flow reasons, paying extra when you can shortens it.