When you are looking to obtain a loan, amortization is a word you might run across. While it is a concept that is fairly easy to understand, many people are not familiar with it. Take just a few minutes today to understand the basics of loan amortization, and how it works so you can apply this knowledge to your loans.
What is Loan Amortization?
Amortization is the process whereby each loan payment made gets divided between two purposes. First, a portion of your payment goes toward paying interest, which the lender calculates based on your loan balance, interest rate, and how much time has passed since the last payment. Second, the remaining part of the payment goes toward paying off the principal, which is the loan balance you owe the lender. When issuing the loan, your lender will use a payment formula to calculate in advance exactly how each payment gets divided. That way, you can have a loan repayment schedule with a specific number of payments of a specific amount.
One key element of loan amortization to note is that the amount of each payment that goes toward principal and interest changes over time. As you pay down your loan balance, the interest portion of each payment decreases. Because the amount of the payment remains the same, this means that the principal portion of each payment increases, which helps you pay off what you owe faster. By the last few payments, you are paying very little interest, and almost your full payment is reducing your loan balance.
What Types of Loans Are Amortized?
Most types of installment loans are amortized loans. An installment loan has a fixed number of payments (also known as installments), and each payment is an equal amount. Some common types of installment loans include mortgages, student loans, auto loans, and some personal loans. If your lender told you exactly how many payments you would be making and each payment is the same amount, it is probably an amortized installment loan. If your payment varies from month to month and you can borrow more money, like with a credit card or home equity line of credit, then it is probably not an amortized loan.
Example of Loan Amortization
The most common amortized loan is a mortgage, so it makes a good example for understanding how amortization works and what its effects are. Let's say you get a mortgage for $200,000 to be repaid over 30 years at 4.5% interest. Your lender will run the calculations and create an amortization schedule of 360 monthly payments of $1,013.37 each.
In this example, the first month, you will owe $750 in interest, based on your mortgage amount and interest rate. The remaining $263.37 of your $1,013.37 monthly payment will go toward repaying the principal. The second month, because your principal balance is slightly lower, you will only owe $749.01 in interest, and you will repay $264.36 of principal. Your 180th payment, halfway through your mortgage repayment, will be $498.68 interest and $514.69 principal. Your final payment will be $3.79 interest and $1,009.58 principal.
Keep in mind that any amortization assumes fixed payments for the duration of the loan. In cases where a borrower has an adjustable rate loan, the amortization schedule will adjust, along with the payment amount with each adjustment to the interest rate.