What does amortization mean?
Updated July 9, 2021
Amortization refers to the repayment of loans in which part of each payment goes to the loan’s principal and part to interest.
With mortgages, amortization means that borrowers pay off their loans over time, in regular installments, which are applied to both principal and interest. A borrower’s amortization schedule is laid out in a table that determines the amount of principal and interest that is repaid with each installment. Typically, early in the loan the majority of repayments go toward interest; later, as the loan matures, more of the borrower’s money goes toward paying off the principal with each repayment they make.
Borrowers repay the same amount of money each month, but as time goes on, more of each repayment is applied to the loan’s principal. This is because as the outstanding balance on the loan gets smaller with each monthly repayment, the amount of interest owed on that balance also shrinks.
How Amortization Is Calculated
Lenders may use financial calculators or charts to determine the distribution of each loan repayment. Borrowers can use formulas to understand how much of each payment will go toward principal and interest.
To calculate the monthly principal you will repay on an amortized loan, use the following formula: Principal Payment = Total Monthly Payment – (Outstanding Loan Balance * (Interest Rate / 12 Months))
To calculate your monthly interest payment, divide your interest rate by the number of payments you’ll make that year. Then, multiply that number by your total outstanding loan balance.
The type of mortgage borrowers take out and the interest rate they lock in determine how much interest and principal will be repaid with each installment, as well as how much total interest the borrower will end up paying off over time. Understanding amortization of a loan helps borrowers predict their expenses, as well as the balance on the loan as it changes with repayments.
Borrowers can opt to make extra repayments on their loans that are applied solely to the principal, which will help them to reduce their interest and pay off the overall loan more quickly.