Amortization

Amortization
Amortization is the process of paying off debt with a fixed repayment schedule. Each amortized payment counts toward both the loan and the interest on the loan.

What is Amortization?

Amortization is the process of paying off a loan through a series of regular and equal payments. Usually, these payments are made on a monthly basis. Each one goes toward the interest as well as the loan balance, which is known as the “principal.”

How does Amortization work?

With an amortized loan, you make the same payment each statement period. To calculate how much you pay, you need to consider four factors: the amount of money you borrowed, the interest rate you agreed to, the length of the loan, and how often you pay. Based on this, you—or more likely your lender—can create a payment schedule that consists of regular, fixed payments. Just plug your numbers into an amortization schedule calculator.

Loans are tricky because when you make a payment, your money goes toward two things: interest and the money you borrowed. However, because the interest you’re charged is based on how much money you still need to pay back, the amount you’re charged is higher at the beginning of the loan.

Here’s an example: If you borrow $100 with a 10 percent interest rate, you’ll owe $10 in interest at the beginning of the loan. If you put $10 toward the principal, that first payment will total $20. (Ten percent interest on $100 plus $10 toward the amount you borrowed.) However, at the end of the loan, when you’ve paid off most of it and only owe, say, $10, the interest you’ll be charged for your last payment will be $1. (Ten percent of $10.) If you put $10 toward the principal like you did before, the total payment will be $11.

An amortization schedule counters this by calculating a plan in which every payment is the same.

Why is Amortization important?

An amortization schedule ensures that you know exactly how much you’ll owe for each payment. It also ensures that you know exactly when you’ll pay the loan back in full. (Of course, you have to follow the schedule to do this.) This helps you plan a budget to meet your financial responsibilities and reduce the likelihood that you’ll fall behind on payments.

The advantage of a loan that uses amortization is that there aren’t any surprises with your payments each month — you’ll always know what you’re paying and how far it goes toward paying down your total debt.

What are the most common types of Amortized loans?

Auto loans, home loans, and personal loans often come with an amortized schedule.1 However, that’s not always the case, so check with your lender. If you have a set repayment period and a fixed amount for each payment, your loan is amortized. Any installment loan is an amortized loan.

What types of loans are not Amortized?

There are three kinds of loans that are not amortized:

  1. Credit cards. With credit cards, you get to choose how much of your balance you pay each month. There’s no repayment schedule, and if you don’t want to pay the full balance one month, your debt will be extended into the next month and you’ll be charged interest. The same is true with cash advances.
  2. Interest-only loans. With this type of loan, you’re initially only responsible for paying interest. But ultimately you’re responsible for paying back the principal too. After the interest-only period, the amount you pay will increase as you put money toward the principal too.
  3. Balloon loans. Balloon loans are one kind of mortgage and auto loans. Unlike an installment-style loan, the amount you pay increases—or “balloons”—at the end of the loan’s life.2

Bottom Line

Amortization can help you stay on top of loan payments. With an amortized loan or installment loan, you’ll know exactly how much you’re required to pay each statement period and how long you’ll have to continue to make payments to repay the loan.

References:

  1. Investopedia. Amortized loan. Retrieved from http://www.investopedia.com/terms/a/amortized_loan.asp
  2. Pritchard, Justin. (2016, August 10). How amortization works. Retrieved from https://www.thebalance.com/how-amortization-works-315522