What is Amortization and How Does it Work?
Amortization is a big word for a simple concept that can help you and your money in important ways.
When you take out a loan, you’re agreeing to certain things. You’re agreeing to pay off the amount you borrow, as well as any other fees and interest that come with it. Amortization is simply the process of paying off your debt over time through regular, fixed payments.1
In order to understand amortization, it helps to know some other terms:
- Principal: The total amount you’re borrowing.
- Interest Rate: The amount you’re charged for borrowing money. This will be expressed as a percentage of the principal.
- Term: The amount of time it takes to repay the loan.2
With an amortizing loan—like an auto loan or mortgage—much of your payments at the beginning of the loan term will go toward paying interest. As the loan progresses and you continue making payments, you’ll start chipping away at the principal as well. By the end of the loan term you will have paid off the entire amount you borrowed, plus all interest associated with the loan.
Which Loans Are Amortizing?
Loans that are usually amortizing would be auto loans, mortgages, personal loans and home equity loans. With these loans your payment, and the interest that accrues, stays the same throughout the life of the loan. This is different from a variable rate loan, which is seen most frequently with credit cards. Having a variable rate loan means that the interest and your payments may not always be the same, which makes it more difficult to calculate how long it will take to pay off the balance.3
Check Out an Amortization Table
The easiest way to understand amortization would be to look at an amortization table or schedule. With an amortization schedule you’ll be able to see several pieces of information, like the total amount you owe, how much interest you owe, how much of your payment is covering interest vs. principal and your remaining balance after each payment.4 Having a visual like this might make you think twice before springing for that new hoverboard. And that’s probably a good thing.
- “Amortization” Investopedia. Accessed February 19, 2016. https://www.investopedia.com/terms/a/amortization.asp
- “Simple Debt Amortization” About.com Mathematics. Accessed February 19, 2016. https://math.about.com/library/weekly/aa101103a.htm
- Pritchard, Justin. “What is an Amortization Table?” About Money. October 21, 2015. Accessed February 19, 2016. https://banking.about.com/od/loans/a/What-Is-An-Amortization-Table.htm
- Pritchard, Justin. “How Amortization Works” About Money. December 23, 2014. Accessed February 19, 2016. https://banking.about.com/od/loans/a/amortization.htm
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