When it comes to loans, amortization is a term that you may have heard. Learn what amortization means and how it works.
What it means
Amortization is the term used to indicate how payments are applied to certain loans. It’s also known as an amortization schedule or table.
Related: Everything you need to know about loans
Typically, payments will be made monthly, and it’ll show the breakdown of how much will go towards the interest and principal.
It’s important to understand that not all loans are amortized. It only applies to installment loans, which have fixed monthly payments.
With installment loans, you have a lump sum as the outstanding balance, and you’ll work on paying it down to zero.
Credit cards and lines of credit aren’t amortized loans. Auto loans, personal loans, and mortgages are.
How amortization works
To understand how amortization works, you must first understand the different aspects. They’re as follows:
- Principal balance. The amount owed without interest.
- Interest or interest payment. The amount that you pay is based on the annual percentage rate (APR). You pay the lender for giving you a loan.
- Scheduled payment. The amount that you’re required to pay each month.
When you get an installment loan, such as a mortgage or a car loan, your lender will show you the amortization schedule. They might call it the payment schedule.
It’ll show you the amount that you must pay each month, which is known as your scheduled payment. It’ll also show how much will go towards interest and principal with each payment.
Initially, the amount that goes towards interest will be higher. Over time, the amount that you pay for interest will decrease, and you’ll be paying more towards the principal amount.
If you’re planning to pay off the loan early, it’s still important to understand the amortization schedule because it tells you the total amount of interest that you’ll pay over the life of the loan.
Examples
The following is an example of an amortization schedule for a $5,000 personal loan with an APR of 5% and a 12-month term.
Month 1 details are as follows:
- Payment: $428.04
- Principal: $407.20
- Interest: $20.83
- Balance left: $4,592.80
Month 2 details are as follows:
- Payment: $428.04
- Principal: $408.90
- Interest: $19.14
- Balance left: $4,183.90
Month 3 details are as follows:
- Payment: $428.04
- Principal: $410.60
- Interest: $17.43
- Balance left: $3,773.29
Month 4 details are as follows:
- Payment: $428.04
- Principal: $412.32
- Interest: $15.72
- Balance left: $3,360.98
Month 5 details are as follows:
- Payment: $428.04
- Principal: $414.03
- Interest: $14.00
- Balance left: $2,946.94
Month 6 details are as follows:
- Payment: $428.04
- Principal: $415.76
- Interest: $12.28
- Balance left: $2,531.18
Month 7 details are as follows:
- Payment: $428.04
- Principal: $417.49
- Interest: $10.55
- Balance left: $2,113.69
Month 8 details are as follows:
- Payment: $428.04
- Principal: $419.23
- Interest: $8.81
- Balance left: $1,694.46
Month 9 details are as follows:
- Payment: $428.04
- Principal: $420.98
- Interest: $7.06
- Balance left: $1,273.49
Month 10 details are as follows:
- Payment: $428.04
- Principal: $422.73
- Interest: $5.31
- Balance left: $850.75
Month 11 details are as follows:
- Payment: $428.04
- Principal: $424.49
- Interest: $3.54
- Balance left: $426.26
Month 12 details are as follows:
- Payment: $428.04
- Principal: $426.26
- Interest: $1.78
- Balance left: $0
The amortization schedule shows you the portions of each payment that are applied to principal and interest.
If you want to pay less interest and pay off the loan sooner, make extra payments. When you pay more than the minimum payment, the extra amount lowers the principal.
Conclusion
Understanding how amortization works and why it’s used helps you with getting a loan. You can make an informed decision when you compare loans from different lenders. You’ll also understand the impact of each payment you make.
More resources:
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About David Em
Founder
David Em is the founder of More Money More Choices, which he launched to help you take control of your finances and build your dream life. Before More Money More Choices, David worked in leadership positions in the finance industry.
