Amortization refers to the series of regular payments you make on a loan to settle both interest charges and the principal balance over time.
If you’re wondering how loan amortization works, here’s what you should know:
What is an Amortized Loan?
It’s a type of loan that is repaid over a certain period, usually with fixed monthly payments. After receiving each payment, your loan servicer will apply part of it to the interest charges of your loan and the rest to the principal balance of the loan. By the end of your repayment term, you will have paid off your loan and interest charges in full.
At the beginning of an amortization schedule, a greater amount of your payment is allocated to interest charges than to paying off your principal balance. However, that proportion will change, and more of your payments will go towards your principal balance until you have paid off your loan completely.
Tip: Many lenders also allow you to make additional payments if you want to get out of debt faster. Just make sure the extra dollars go toward the principal balance, shorten the loan’s repayment term, and reduce the total interest paid over the life of the loan.
What is a Loan Amortization Schedule?
A loan amortization schedule is typically a table that shows how your payments are applied to your balance each month, which includes the following information:
a) How much of your payment goes toward the principal balance each month (this amount will increase over time).
b) How much of your payment goes toward interest charges each month (this amount will decrease over time).
c) Your remaining balance after each payment.
Your amortization schedule might also contain the following information about your loan:
Loan amount, repayment term, and interest rate.
Amount of your payments, which you’ll typically make monthly.
Total number of loan payments you’ll make on your loan.
Why Loan Amortization Matters
Loan amortization helps you understand how payment works on your loan over time. In any given month, you can refer to your amortization schedule to see how much of your payment is being applied to your principal balance and how much is going toward interest. You’ll also see your remaining balance and how much more you must pay to settle the debt in full.
Ultimately, understanding the payment terms and schedule of your loan can help you better manage your finances and devise a debt repayment plan that works for you and your financial goals.
What’s the Main Purpose of Loan Amortization
A loan amortization schedule gives you a comprehensive picture of how your loan payments are applied to your principal balance and interest each month. It also shows how your balance decreases over time and how much you’ll pay in total interest.
Loan amortization is important because it helps you understand how payment works on your loan over time. In any given month, you can refer to your amortization schedule to see how much of your payment is being applied to your principal balance and how much is going toward interest. You’ll also see your remaining balance and how much more you must pay to settle the debt in full.
Ultimately, understanding the payment terms and schedule of your loan can help you better manage your finances and devise a debt repayment plan that works for you and your financial goals.
Simple Interest
Simple interest is a particular type of interest you can use to pay off a loan. The key aspect to understand about simple interest is that it has a fixed interest rate, meaning the interest rate agreed upon when you get the loan remains the same throughout the loan’s repayment period. It’s called simple interest because it’s the simplest expression of the interest rate. It’s a percentage of the principal amount and is paid in addition to the principal in each payment.
Amortization
If you’re using amortization to pay off a loan, you’ll use an amortization schedule. This schedule will give you an accurate picture of how the terms of the amortized loan will affect the resulting payment process, so you know what you owe and when you owe it.
Interest is compounded with amortized loans, and the frequency of interest compounding will match the frequency of your payments, whether daily, weekly, or monthly. When looking for loans, you can compare various amortization payment schedules to figure out an exact payment plan and schedule that fits your fixed cash flow.
Although amortization may seem a bit more complicated than simple interest in terms of formula, the principle of the process is relatively straightforward. This payment model employs variable amounts of principal and interest with each installment. This means amortized loans will require high-interest payments at the beginning, but they will gradually decrease over time. This decrease is because, with each payment, you’ll only be paying interest on the outstanding amount. The initial payments will make you pay the highest interest payment along with the lowest principal amount. With subsequent payments, you’ll start paying higher amounts in principal and increasingly lower amounts in interest payments.