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Any time you take out a loan, you’ll have to pay it back with interest. When you borrow money, your lender will provide you with an amortization schedule. That may sound like a confusing term, but amortization is really just the process of spreading your loan amount out over a fixed period of time.
Your amortization schedule explains how many monthly payments you’ll make, how much you’ll pay each month, and what portion of your payment goes toward interest versus your principal balance. This schedule helps you better understand what you’re paying for at what point in your loan, and when you’ll finally start making a dent in your equity.
Wondering how to calculate your amortization? There’s a mathematical formula you can use to figure out your own payment schedule, but you can also use an online amortization calculator to do the work for you.
Amortization is the process of paying off debt on a set schedule, with payments spread out over a number of years. When you borrow money, the lender uses an amortization formula to figure out how much your monthly payments are each month so you can pay your loan off on time.
Each month, a portion of a borrower’s payment goes toward the principal balance, while the rest of it goes toward interest. With some types of loans, the payments will look different depending on where you are in the loan term.
For example, in the case of a mortgage’s amortization, payments made in the early years consist primarily of interest. The further into the mortgage you get, the more of your payments go toward the principal.
Amortization occurs over a different timeline for different types of loans. Mortgages are typically amortized over 30 years, meaning the borrower makes set monthly payments for 30 years until the loan is repaid. For a personal loan or car loan, amortization might occur over just a few years. When you borrow money for any reason, your lender will likely provide you with an amortization schedule. This schedule will tell you how many payments you’ll make and how much you’ll have to pay each month.
The amortization schedule you’ll receive assumes that you’re making the minimum required payment each month. You often can pay down your loan more quickly by making larger payments, and therefore save money on interest. Just be sure your loan doesn’t have an early payoff penalty.
Amortization applies to fixed loans like mortgages and auto loans, but it doesn’t apply to all debt. Credit card debt, for example, isn’t amortized. The interest is calculated separately each month, and how much you pay will depend on your current credit card balance.
As a borrower, understanding amortization is beneficial because it gives you a greater comprehension of how your loan works. It helps to explain how your lender decides how much your monthly payments will be.
Definitions to know
Before you borrow money, it’s important that you understand the amortization process and the important words and phrases in your loan terms.
Some terminology you’re likely to come across includes:
- Principal: The principal of a loan is the initial amount you borrow. Suppose you borrow $10,000 to buy a car. You ultimately end up paying quite a bit more with fees and interest, but the $10,000 is still your loan principal. The amount of interest you’re charged at any given time is based on the remaining principal balance.
- Interest rates: Interest refers to the money that you pay in addition to your principal balance when you pay back a loan. Think of it as the cost of borrowing money. The interest rate on any given loan is the specific amount you’ll pay. Different factors can impact the interest rate, including the type of loan and your creditworthiness as a borrower.
- Number of payments: When you take out a loan, the contract will contain loan terms, including a payment schedule. The payment schedule will include the number of payments you’ll make to pay back your loan and how much each payment will be.
- Amortization: Amortization is the process of paying off debt on a set schedule, with payments spread out over several years.
- Lender: The lender in a loan relationship is the party that lends money to the other with the expectation that they will be paid back on time with interest.
- Borrower: The borrower in a loan relationship is the one who receives money from the other party. They’ll have to eventually pay back the agreed-upon amount based on the terms laid out in the contract.
[ Read: Best Mortgage Lenders for November 2020 ]
Lenders use an amortization formula to determine the amortization schedule of your loan. The formula uses the principal loan amount, interest rate and total number of payments to determine how much each payment will be.
Here’s what goes into the formula:
- M = monthly payment
- P = principal loan amount
- r = monthly interest rate (keep in mind that the rate your lender gives you is an annual rate, so you’ll have to divide that rate by 12 to find your monthly interest rate.
- n = number of payments. The total number of payments is the number of years of the loan (which you should know upfront) multiplied by 12 months per year.
The amortization formula looks like this:
M = P [ r (1+r) ^ n / ((1+r) ^ n) -1) ]
Let’s use this formula with a real-world example to help give an understanding of how it really works. Suppose you’re borrowing $10,000 at a rate of 4% to buy a car. The loan term is three years. For the purposes of this example, these are the figures you need for the formula:
- P = $10,000
- r = .33% (the 4% annual rate divided by 12)
- n = 36 (the three-year term multiplied by 12 months per year)
For the first month, the amortization formula would look like this:
M = 10,000 [ .33 (1+.33) ^ 36 / ((1+.33) ^ 36) -1) ]
Your monthly payments for this loan would be $295.24. In the first month, $261.91 of your payment goes toward principal, while the other $33.33 goes toward interest.
As you progress through the loan, you’ll pay less and less each month toward interest. And don’t worry — you don’t have to run the formula yourself! You can find an amortization calculator online that will do the math for you.