What is Amortization?

Definition and Examples of Amortization

Amortization is the way loan payments are applied to certain types of loans. Typically, the monthly payments stay the same, and are divided between interest costs (what your lender pays for the loan), reducing your loan balance (also known as “paying off principal”), and other expenses such as property taxes.

Your last loan payment will pay off the final remaining amount of your debt. For example, after exactly 30 years (or 360 monthly payments), you will pay off a 30-year mortgage. The amortization table helps you understand how a loan works, and it can help you predict your outstanding balance or interest expense at any point in the future.

How Amortization Works

The best way to understand amortization is to review an amortization table. If you have a mortgage, that table is included with your loan documents.

An amortization table is a schedule that lists each monthly loan payment as well as how much of each payment is for interest and how much is for principal. Each amortization table contains the same type of information:

  • Scheduled payments: The monthly payments you need are listed one by one by month over the term of the loan.
  • Principal payments: After you apply interest charges, your remaining payments are used to pay off your debt.
  • Interest expenses: Of each scheduled payment, a portion goes to interest, which is calculated by multiplying your remaining loan balance by your monthly interest rate.

Although your total payments remain the same each period, you will pay different amounts of interest and principal each month. At the beginning of the loan, interest costs are highest. Over time, more of each payment goes into your principal, and you pay proportionately less interest each month.

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Example of Amortization Table

Sometimes it’s helpful to look at the numbers instead of reading about the process. The table below is known as the “amortization table” (or “amortization schedule”). It shows how each payment affects the loan, how much you pay in interest, and how much you owe on the loan at any given time. This amortization schedule is for the beginning and end of the car loan. This is a $20,000 five-year loan that bears 5% interest (with monthly payments).

Monthly Balance (Initial) Payment of Principal Interest Balance (End)
1 $20,000.00 $377.42 $294.09 $83.33 $19,705.91 2 $19,705.91 $377.42 $295.32 $82.11 $19,410.59 3 $19,410.59 $377.42 $296.55 $80.88 $19,114.04 4 $19,114.04 $377.42 $297.78 $79.64 $18.816.26 . . . . . . . . . . . . . . . . . . . . . . . . 57 $1,494.10 $377.42 $371.20 $6.23 $1,122.90 58 $1,122.90 $377.42 $372.75 $4.68 $750.16 59 $750.16 $377.42 $374.30 $3.13 $375.86 60 $375.86 $377.42 $374.29 $1.57 $0

Amortization Table

To view the full schedule or create your own table, use the loan amortization calculator. You can also use a spreadsheet to create an amortization schedule.

Types of Amortization Loans

There are many types of loans available, and not all of them work the same way. Installment loans are amortized, and you pay the balance to zero over time with tiered payments. They include:

Car Loan

This is often a five-year (or shorter) amortization loan that you pay off in fixed monthly payments. Longer loans are available, but you’ll be spending more on interest and reverse risk on your loan, meaning your loan exceeds the resale value of your car if you stretch too long to get a lower payment.

Home Loan

These are often 15 or 30 year fixed rate mortgages, which have a fixed amortization schedule, but there are also adjustable rate mortgages (ARMs). With ARM, lenders can adjust rates on a predetermined schedule, which will affect your amortization schedule. Most people don’t keep the same home loan for 15 or 30 years. They sell the house or refinance the loan at some point, but these loans work as if the borrower is going to keep it for the entire term.

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Personal loan

These loans, which you can get from banks, credit unions, or online lenders, are also generally amortized loans. They often have three-year terms, fixed interest rates, and fixed monthly payments. They are often used for small projects or debt consolidation.

Unamortized Loans and Loans

Some loans and loans have no amortization. They include:

  • Credit card: With this, you can borrow repeatedly on the same card, and you can choose how much you will pay each month as long as you meet the minimum payments. This type of loan is also known as “revolving debt”.
  • Interest only loans: These loans are also not amortized, at least not at the outset. During the interest-only period, you will only pay the principal if you make optional additional payments above and beyond the interest expense. At some point, the lender will ask you to start paying principal and interest on an amortization schedule or pay off the loan in full.
  • Balloon loans: This type of loan requires you to make a large principal payment at the end of the loan. During the early years of the loan, you will make small payments, but the entire loan will eventually come due. In most cases, you will likely refinance the balloon payout unless you have a large amount of money on hand.
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Amortization Benefits

Looking at amortization is helpful if you want to understand how borrowing works. Consumers often make decisions based on affordable monthly payments, but interest expense is a better way to gauge the true cost of what you’re buying. Sometimes a lower monthly payment actually means you’ll be paying more interest. For example, if you extend the payment term, you will pay more interest than the shorter payment term.

Don’t assume all loan details are included in the standard amortization schedule. Some amortization tables show additional details about a loan, including costs such as closing costs and cumulative interest (a running total that shows the total interest paid after a certain period of time), but if you don’t see these details, check with your lender.

With the information listed in the amortization table, it is easy to evaluate various loan options. You can compare lenders, choose between 15 or 30 year loans, or decide whether to refinance an existing loan. You can even calculate how much you will save by paying off debt early. With most loans, you will miss any remaining interest costs if you pay them off early.

Key Takeaways

  • Amortization is the process of spreading a loan into a series of fixed payments. Loans are repaid at the end of the repayment schedule.
  • Some of each payment goes towards interest costs, and some goes towards your loan balance. Over time, you pay less interest and more to your balance.
  • The amortization table can help you understand how your payments are applied.
  • Common amortization loans include auto loans, home loans, and personal loans.
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