Amortization: Definition and Examples
If you have ever had to pay back a loan, you have already experienced amortization. When you get a loan, the lender spreads out your repayment amount over a series of fixed payments. Once you finish this payment schedule, your loan is officially paid off.
How Does Amortization Work?
Basically, amortization allows you to pay fixed payments until a loan is paid off. Each time you make a payment, a portion of your payment covers the loan’s principal. The rest covers the interest costs. While you pay more interest costs initially, your payments will gradually focus on principal as you pay off your loan.
You can see how this process works using an amortization calculator. Amortization can occur with car loans, personal loans and home loans.
If you really want to understand how amortization works, you should check out this amortization table.
This kind of table comes with any mortgage you get. The table basically lists how much of each payment will go to interest and principal each month.
When you look at an amortization table, you will see some of the following details.
- Interest costs: Each time you make a payment, some of your payment will end up covering interest costs. The lender calculates this amount by multiplying your loan balance by your monthly interest rate. As your loan balance shrinks, your interest expenses will decline as well.
- Scheduled payments: Your amortization table will always include your scheduled payments. These monthly payments are listed individually for the duration of your loan.
- Principal payments: Once you pay your monthly interest costs, the rest of your payment ends up going toward the principal balance on your loan.
If you pay extra money each month, you can pay off your loan early. Normally, your scheduled payment will cover interest expenses before the principal can be repaid. When you pay extra, your additional payment will go entirely toward your loan’s principal.
During the life of your loan, the total payment will remain the same. While the payment is the same, the interest and principal amounts will vary. Interest costs are always the highest with new loans. As you make more payments, a smaller portion of each payment will go toward your interest expenses.
What Is Amortization?
Amortization is the way your loan payments pay off your loan. The monthly payment normally remains the same throughout the loan’s term, but the division of each payment changes. While a larger portion of the payment goes toward interest expenses initially, the interest portion of the payment gradually declines as you pay off the loan. Once you make your final payment, your loan will be paid off.
How Do You Amortize a Loan?
You can amortize a loan by taking the entire amount of your loan and multiplying it by the loan’s interest rate. Afterward, you must divide this number by 12 to get the amount you will pay in monthly interest. Next, you should subtract your interest payment from your monthly loan payment. The remaining amount is how much you will pay in principal payments each month.
For example, we can look at what your payment will be for a $100,000 loan. Right now, we will assume that you have $90,000 left on your mortgage loan. Your loan is a 30-year mortgage with an interest rate of 4 percent. This means you must pay a monthly payment of $477 per month.
Your current loan total is $90,000, so you should start by multiplying this figure by 4 percent. This works out to $3,600. To get your monthly interest payment, you divide $3,600 by 12 to get $300. This means each $477 payment will consist of $300 in interest costs and $177 in principal payments.
Calculate Amortization Using Monthly Interest Rates
You can actually get even more exact by incorporating your monthly interest rate and your changing principal amount from each month. With an annual rate of 4 percent, you pay 0.33 percent in interest each month. When you do the math, you get the same result for the first month. You will still pay $300 in interest and $177. This method is more accurate for the entire year because of what happens during the following months.
Thanks to your payment last month, you have paid $177 in principal costs and only owe $89,823. Using the same technique, we can see that you must pay $296.41 in interest now. This means that $180.59 of your upcoming payment will go toward the loan’s principal. While calculating amortization with monthly interest is more accurate, you will still get a fairly good approximation using the annual interest rate as well.
What Are the Advantages of Using Amortization?
Amortization is a useful way to understand how loans work. When you initially applied for a loan, you probably looked at the monthly payment to determine if you could afford it or not. If you really want to know how much your loan will cost, you have to consider the interest expenses as well. In many cases, a lower monthly payment means you will end up paying more in interest payments over the course of your loan term.
You can use an amortization table to compare different loan terms. When you look at these tables, you should remember that they will only incorporate some of the information. They will not include closing costs, origination fees or similar details. If you need more information, you can always ask your lender for help.
What Kinds of Loans Use Amortization?
A large number of loans use amortization. While they might amortize in a similar way, there are many distinct differences between each kind of loan. As a general rule, all installment loans use amortization.
- Home loans: Home loans are generally available with a 15-year or 30-year term. While most mortgages have a fixed amortization schedule, adjustable-rate mortgages (ARMs) do not. Lenders can adjust the rate on ARMs at set times, which can significantly impact your amortization schedule.
- Personal loans: Personal loans are normally amortized. They are generally for three-year or five-year terms, but you can occasionally get a personal loan for longer or shorter time periods. You can get a personal loan from an online lender or bank to pay for renovations, debt consolidation, vacations and other personal goals.
- Car loans: Car loans are generally for three to eight years. You must repay your car loan using a fixed payment each month. If you get a longer loan term, you will end up spending more on interest costs.
Which Loans Are Not Amortized?
Most loans are amortized. Balloon loans and similar loans are not. If you get one of the following loan types, you will probably not use amortization.
- Interest-only loans: An interest-only loan does not amortize when you start paying it. During this initial period, you are only making interest payments. You only reduce the loan’s principal if you make extra payments. Later on, the lender will require you to start making principal payments as well.
- Credit cards: Credit cards allow you to choose how much you borrow and repay each month. This type of revolving debt allows you to pay a minimum amount, which is convenient for your monthly budget. If you only make the minimum payment, it can take you years to pay off your credit card completely.
- Balloon loans: With a balloon loan, you start out making small payments that primarily cover the interest expenses on the loan. At the end of the loan, you are required to make a large principal payment. Because most people do not have enough money to make these large payments, they normally refinance the loan before the payment is due. The 2008 recession was partially caused by balloon loans because so many people were unable to afford the balloon payments at the end of the loan term.
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About Ben Broadwater
Ben Broadwater is the Director of Investment U. He has more than 15 years of content creation experience. He has worked and written for numerous companies in the financial publishing space, including Charles Street Research, The Oxford Club and now Investment U. When Ben isn’t busy running Investment U, you can usually find him with a pair of drumsticks or a guitar in his hand.