Amortization Explained

Put simply, amortization is the process of paying off a debt, such as a mortgage or auto loan, in equal installments over a certain period of time. When someone takes out a loan, they are typically provided with an amortization schedule for their amortization loan by then lender. This document outlines the monthly payment, with due dates and how much of the payments will go toward interest versus the principal. Understanding amortization is very important for borrowers because it provides a specific outline of their payments and the borrower can see just how much they will be paying in interest over time. It also provides clarification on why borrowers pay less on principal at the beginning of a loan term and more at the end.

“An amortization schedule allows full transparency to the borrowers. They will know exactly how much of their payments are going to principal and interest, which allows them to understand where their payments are going and when the loan will be paid off,” Alyssa Inglis, a credit union lending officer, said.

How to calculate amortization

To determine the amortization of a loan, multiple formulas and values are needed to get there.
1. Loan payment = Amount / Discount Factor (P = A / D)
2. (n) = the number of payments over the life of the loan
3. (i) = interest rate divided by the number of monthly payments per year
4. (D) = discount factor formula ((D) = {[(1 + i) ^n] – 1} / [i(1 + i)^n])
5. (a) = the loan amount

Here’s an example amortization formula. This is on a 30-year fixed mortgage of $200,000 with an interest rate of 4.5%:
1. (n) = 360 (30 years with 12 months per year)
2. (i) = .00375 (4.5% interest rate, as .045, divided by 12 months in a year)
3. (D) = {[(1+.00375)^360] – 1} / [0.00375(1+.00375)^360]
4. (D) = 197.36
5. P = A / D
6. Loan payment = $200,000 / 197.36
7. Loan payment = $1,013.37

Now, let’s take a look at an example amortization schedule. This schedule a years worth of payments for the same 30-year fixed mortgage of $200,000 with an interest rate of 4.5%.

Payment Date

 Payment Principal Interest Total Interest Balance
Month 1 $1,013.37 $263.37 $750.00 $750.00 $199,736.63
Month 2 $1,013.37 $264.36 $749.01 $1,499.01 $199,472.27
Month 3 $1,013.37 $265.35 $748.02 $2,247.03 $199,206.92
Month 4 $1,013.37 $266.34 $747.03 $2,994.06 $198,940.58
Month 5 $1,013.37 $267.34 $746.03 $3,740.09 $198,673.23
Month 6 $1,013.37 $268.35 $745.02 $4,485.11 $198,404.89
Month 7 $1,013.37 $269.35 $744.02 $5,229.13 $198,135.54
Month 8 $1,013.37 $270.36 $743.01 $5,972.14 $197,865.17
Month 9 $1,013.37 $271.38 $741.99 $6,714.13 $197,593.80
Month 10 $1,013.37 $272.39 $740.98 $7,455.11 $197,321.40
Month 11 $1,013.37 $273.42 $739.96 $8,195.06 $197,047.99
Month 12 $1,013.37 $274.44 $738.93 $8,933.99 $196,773.55

Types of amortization loans

The most common types of amortization loans are home, auto and personal loans. These loans allow individuals to purchase a home, purchase a car or use borrowed funds for other financial needs.

Home loans

If someone wants to purchase a home, they’re most likely going to have to take out a home loan, also known as a mortgage. This is usually the largest loan people will borrow in their lifetime, and these loans come with a wide range of terms and interest rates. Whether someone is in the market for a fixed-rate mortgage or a variable-rate mortgage, there is usually a solution available that will fit their financial needs. A borrower will also pay the most amount of interest on this type of loan. If we take our example from above (30-year fixed mortgage worth $200,000 with a 4.5% interest rate), the borrower will pay more than $160,000 in interest over the life of the loan if they are only making their monthly payment. In addition to the amount of interest paid, about 70-75% of their monthly payment will be applied to interest within the first year.

Auto loans

Financing a vehicle can allow a person to purchase a new or used vehicle without having to save thousands to pay out of pocket. Auto loans usually come with terms from 12 months to 72 months, but depending on the lender, borrowers can even get a term up to 84 months. As an example, let’s say a borrower finances a vehicle for $20,000 for 60 months (5 years) at an interest rate of 3.99%. This gives them a monthly payment amount of $368.24, and this borrower should expect to pay about 15-20% of their monthly payment in interest within the first 12 months, along with nearly $2,100 in interest over the life of the loan.

Personal loans

Perhaps one of the most versatile loans available, a personal loan can be used for various different reasons. Many borrowers use the funds to consolidate debt, pay medical bills, make small home improvements or for any other needs they may have. These loans are typically a fixed rate and terms can be anywhere from 12 months to 84 months depending on what the lender offers. Borrowers receive the funds in one lump sum and then pay back the amount in installments based on the term.

Oftentimes, personal loans have a lower interest rate than major credit cards, which makes them appealing to pay off high-interest cards and consolidate multiple payments into one.

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The bottom line

Loan amortization can seem complicated, but understanding how it works can provide borrowers with the power to set various goals in order to pay debt off faster. It also can show where exactly their money is going and when they can expect to see their principal balance decrease more. Whether a loan is worth $5,000 or $500,000, amortization is an important component in the bigger financial picture of the loan.

Courtney Leigh
Courtney Leigh
Writer for The Simple Dollar

Courtney Leigh has been in the financial industry for over six years, with a primary focus on personal finances. She graduated from the University at Albany - SUNY, located in Albany, NY, in 2017 with a Bachelor of Arts in Journalism and a Bachelor of Arts in Communications. Courtney's career has led her down a financial Marketing path, where she is a member of the copy team at a large credit union in Phoenix, Arizona where she currently resides with her loving pup, Emmie.

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