What is amortization?

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The word “amortization” refers to the systematic elimination of a loan’s principal balance (and interest due) through regular payments over a pre-determined time frame. The regular payments must be sufficient to cover both the principal payment and the interest payment.

Amortization is derived from the Latin words “ad” and “mort,” which means “to death.” In plain English, amortization refers to the process of paying down a loan – along with all interest charges and loan fees due.

Amortization of loans is mainly used by financial accountants, lenders and loan borrowers, in which case it implies reducing the principal amount over the life of a loan.

Each time a loan borrower makes a monthly loan payment, a small portion of that payment is used to reduce the principal amount while the other portion is applied towards paying the interest expense on the loan.

  • More precisely, with standard loan amortization, the monthly payments are first used to pay any interest due for that month.
  • Any remaining payment amount will then be used to pay down the principal balance.

By reducing the principal balance, the interest charge the next month should be lower (if the interest rate is fixed). That means there will be more available to pay down the loan principal.

  • The resulting trend with standard loan amortization is that at the beginning of the loan’s life, the bulk of the monthly payments go toward interest, while only a small amount goes toward lowering the principal.
  • However, in the second half of the loan’s term, less of the monthly payments will have to go toward interest charges – while the principal balance will decrease at a faster rate.

Amortization Schedule

Consumer and personal loan providers typically provide an amortization schedule to their new borrowers, especially with long-term loans. The amortization schedule is a table which contains detailed information about each periodic payment on a mortgage loan or a traditional loan.

The periodic payment is usually calculated using an amortization calculator. When you make a payment, the principal amount gradually decreases and when it reaches zero, you will have paid off your loan plus the interest in full. Accountants regularly check the amortization schedule to make sure that there are no errors or omissions.

Amortization Formula

As stated earlier, the periodic principal balance can be easily calculated using a financial calculator.

One variation of the formula used to calculate the amortization schedule is as shown below:

Amortization-formula

Where:

  • P - Represents the principal loan amount in a particular loan term
  • A - Represents the regular or periodic payments
  • R - Represents the interest rate (if the interest rate is annual, it should be divided by 12 to get the monthly interest rate)
  • N - Represents the loan period (for which you want to determine the current loan balance)

This formula will provide the current principal balance of the loan at any given period in the loan’s projected term. For example, if the original loan amount on a 15-year fixed-rate loan was $150,000, with an interest rate of 4.50%, the monthly P&I (principal and interest) payment would be $1,1147.49.

This 15-year loan would have 180 months of scheduled payments. If we project to the 24th month, the principal balance at that time would be about $135,337. By the 168th month (one year from the loan’s scheduled maturity), the principal balance would be down to about $13,440.

Time Frame

The term of the loan depends on the specific financing that the borrower and lender have agreed upon. Short-term cash advance loans, for example, have terms of one to three months, requiring full payment as quickly as the next scheduled paycheck the borrower receives. Personal loans usually have terms that stretch from 6 months to five years. Car loans typically have loan terms of three to five years, while most mortgage loans are amortized for 15 or 30 years.

That loan term, along with the interest rate and loan amount, will determine the monthly payment amount used in the above amortization formula.

Conclusion

An amortization schedule provides loan borrowers with a useful in determining what their current loan balance will be at any point during the life of the loan (assuming that payments are made on time and the interest rate does not change).

Just as important, an amortization schedule shows how loan payments are divided between interest charges and principal balances over the life of the loan.

Disclaimer: NetCredit is a direct personal loan provider and does not provide financial advice, nor does it vouch for any vendor or service mentioned on our NetCredit personal finance blog or online consumer loan glossary. Always research and perform due diligence on any service provider or vendor before deciding to use them, and we recommend that you speak with a financial advisor regarding all decisions that will affect your finances.

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