- Loans
ByJustin Pritchard
Updated on May 10, 2022
Reviewed byCierra Murry
In This Article
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In This Article
- Definition and Examples of Amortization
- How Amortization Works
- Types of Amortizing Loans
- Credit and Loans That Aren't Amortized
- Benefits of Amortization
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Definition
Amortization is the process of spreading out a loan into a series of fixed payments. The loan is paid off at the end of the payment schedule.
Definition and Examples of Amortization
Amortization is the way loan payments are applied to certain types of loans. Typically, the monthly payment remains the same, and it's divided among interest costs (what your lendergets paid for the loan), reducing your loan balance (also known as "paying off the loan principal"), and other expenses like property taxes.
Your last loan payment will pay off the final amount remaining on your debt. For example, after exactly 30 years (or 360 monthly payments), you’ll pay off a 30-year mortgage. Amortization tables help you understand how a loan works, and they can help you predict your outstanding balance or interest cost at any point in the future.
How Amortization Works
The best way to understand amortization is by reviewing an amortization table. If you have a mortgage, the table was 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 goes to interest and how much to the principal. Every amortization table contains the same kind of information:
- Scheduled payments: Your required monthly payments are listed individually by month for the length of the loan.
- Principal repayment: After you apply the interest charges, the remainder of your payment goes toward paying off your debt.
- Interest expenses: Out of each scheduled payment, a portion goestoward interest, which is calculated by multiplying your remaining loan balance by yourmonthly interest rate.
Although your total payment remains equal each period, you'll be paying off the loan's interest and principal in different amounts each month. At the beginning of the loan, interest costs are at their highest. As time goes on, more and more of each payment goes toward your principal, and you pay proportionately less in interest each month.
An Example of Amortization
Sometimes it’s helpful toseethe numbers instead of reading about the process. The table below is known asan "amortization table"(or "amortizationschedule"). It demonstrates 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 an auto loan. This is a $20,000 five-year loan charging 5% interest (with monthly payments).
| Month | Balance (Start) | Payment | 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 |
To see the full schedule or create your own table, use aloan amortization calculator. You can also use a spreadsheet to create amortization schedules.
Types of Amortizing Loans
There are numerous types of loans available, and they don’t all work the same way. Installment loansare amortized, and you pay the balance down to zero over time with level payments. They include:
Auto Loans
These are often five-year (or shorter) amortized loans that you pay down with a fixed monthly payment. Longer loans are available, but you'll spend more on interest and risk beingupside down on your loan, meaning your loan exceeds your car's resale value if you stretch things out too long to get a lower payment.
Home Loans
These are often 15- or 30-yearfixed-rate mortgages, which have a fixed amortization schedule, but there are also adjustable-rate mortgages (ARMs). With ARMs, the lender can adjust the rate on a predetermined schedule, which would impact your amortization schedule. Most people don’t keep the same home loan for 15 or 30 years. They sell the home orrefinance the loanat some point, but these loans workas ifa borrower were going to keep them for the entire term.
Personal Loans
These loans, which you can get from a bank, credit union,or online lender,are generally amortized loans as well. They often have three-year terms, fixed interest rates, and fixed monthly payments. They are often used for small projectsor debt consolidation.
Credit and Loans That Aren't Amortized
Some credit and loans don't have amortization. They include:
- Credit cards:With these, you can repeatedly borrow on the same card, and you get to choose how much you’ll repay each month as long as you meet the minimum payment. These types of loans are also known as"revolving debt."
- Interest-only loans:These loans don’t amortize either, at least not at the beginning. During the interest-only period, you’ll only pay down the principal if you makeoptionaladditional payments above and beyond the interest cost. At some point, the lender will require 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 atthe end of the loan. During the early years of the loan, you’ll make small payments, but the entire loan comes due eventually. In most cases, you’ll likely refinance the balloon payment unless you have a large sum of money on hand.
Benefits of Amortization
Looking at amortization is helpful if you want to understand how borrowing works. Consumers often make decisions based on an affordable monthly payment, but interest costs are a better way to measure the real cost of what you buy. Sometimes a lower monthly payment actually means that you’ll pay more in interest. For example, if you stretch out the repayment time, you'll pay more in interest than you would for a shorter repayment term.
Note
Don't assume all loan details are included in a standard amortization schedule. Some amortization tables show additional details about a loan, including fees such as closing costs and cumulative interest (a running total showing the total interest paid after a certain amount of time), but if you don't see these details, ask your lender.
With the information laid out in an amortization table, it’s easy to evaluate different loan options. You can compare lenders, choose between a 15- or 30-year loan, or decide whether torefinance an existing loan. You can even calculate how much you’d save bypaying off debt early. With most loans, you’ll get to skip all of the remaining interest charges if you pay them off early.
Key Takeaways
- Amortization is the process of spreading out a loan into a series of fixed payments. The loan is paid off at the end of the payment schedule.
- Some of each payment goes toward interest costs, and some goes toward your loan balance. Over time, you pay less in interest and more toward your balance.
- An amortization table can help you understand how your payments are applied.
- Common amortizing loans include auto loans, home loans, and personal loans.
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Part Of
How Does Loan Amortization Work?
- What Is Amortization?1 of 5
- What Is a Fixed-Rate Loan?2 of 5
- What Is the Formula for a Monthly Loan Payment?3 of 5
- Amortization Calculator4 of 5
- Why Pay Off Loans Early?5 of 5
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