An amortization schedule, sometimes just called an amortization, is the predetermined timetable identifying the payment amount, duration and payment dates of a loan that is paid off over time. Another use of the term amortization is the gradual reduction of the initial loan amount issued by a lender – through the scheduled payments.
To begin, calculating the loan amortization relies on the four basic loan components:
An amortization schedule identifies the original and ongoing loan balance, the interest rate applied to the loan, the length of the loan (term) and the periodic payment owed to the lender. In other words, an amortization schedule can tell borrowers what the loan balance, interest due and monthly payment breakdown for any scheduled payment – whether it’s the 5th or 55th scheduled payment for the loan.
With standard, fully amortized loans, each scheduled payment consists of a portion of the outstanding loan balance and a portion of interest due the lender. In other words, each monthly payment on a fully amortized loan typically covers the interest due for that period, as well as a growing amount to pay down the principal.
|Monthly Payment Breakdown|
|Loan payments are divided between…|
|1. Interest due on loan||2. Payment toward principal|
The amortization schedule will show the effect of the monthly payments as it relates to interest paid, both monthly and cumulatively, as well as the current outstanding principal balance.
A loan is considered fully amortized when the scheduled payments pay off the loan completely on the scheduled date. The amortization schedule shows the monthly payment as well as how much is allotted to interest and how much to the outstanding loan balance. Monthly payments at the beginning of an amortized loan will show more interest paid the lender and less as the loan balance is reduced.
The shifting of interest paid each month is due to the interest being calculated on the remaining loan balance.
The loan principal balance is at its highest at the very beginning of the loan term, so there is more interest charges to pay. With more interest due, more of the initial payment is applied to interest. As the principal balance is gradually reduced, the share to interest drops.
Here’s another way to look at it (with a fully amortized loan):
In the beginning of most fully amortized loans, the bulk of monthly payments are for interest. By the end of the loan term, it’s flipped around: most of the monthly payments are for the loan principal balance.
For example, a five year loan of $10,000 at 8.00 percent results in a monthly payment of $202.76.
Amortization is a term used heavily in the financial services industry and is not easily understood by many consumers.
Amortization is easy to calculate when the loan’s interest rate is fixed for the entire life of the loan. However, it gets a bit more complicated with adjustable or variable rate financing, such as ARM loans. Because interest rates can change every year, the interest charges (and total monthly payment) will also change. Nevertheless, even an ARM loan, when fully amortized, will calculate payments to pay off the loan in full in the defined term.
Amortization is derived from the Latin root word “mort,” or death. At the end of the amortization period, the loan does indeed “die” once all the scheduled payments have been made.
Whether you’re dealing with a 12-month personal loan, a five-year auto loan or a 30-year mortgage loan, make sure to review your amortization schedule. It provides a numeric month-by-month breakdown of how your payments will pay down your loan while also paying for any interest charges that may be due.
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