Loan amortization: How does it work?
September 27, 2022 4 min read
Amortization might sound a little intimidating, but it’s actually pretty simple. Loan amortization is the process of paying off the interest and principal balance on a loan with regular payments over time.
But there’s a lot more to know about how loan amortization works, what a loan amortization schedule is and why it all matters. Keep reading to learn more.
- Loan amortization is the process of paying off a loan by making regular payments over time.
- Usually, a portion of each loan payment goes toward paying off the interest, and a portion goes toward paying off the principal.
- A higher percentage of the payment will typically go toward paying the interest in the beginning of a loan term. Later in the loan term, a higher percentage will usually go toward the principal balance.
- A loan amortization schedule shows borrowers how their loan payments will be split between paying off the interest and principal over time.
What is loan amortization?
Loan amortization refers to the process of paying off a loan over time on a set schedule. Typically, a portion of the payment goes toward paying off the interest, and a portion goes toward paying off the principal balance.
So what does all of this mean?
The principal is the amount of money originally borrowed from the lender. And the principal balance is whatever part of the original principal the borrower still needs to pay off.
Some loans have a fixed interest rate. And some loans have a variable interest rate. You can learn more about how fixed rates and variable rates differ.
With fixed-rate loan amortization, the loan payments will typically be fixed, equal amounts. With variable-rate loan amortization, the loan payments could change as the interest rate changes.
How does loan amortization work?
At the beginning of the loan term, more of the payment generally goes toward interest than the principal balance. But as the loan term progresses, more and more of the payment will usually go toward paying off the principal balance and less will go toward interest.
This is especially true of fixed-rate loans, because the interest rate generally stays the same, while the principal balance steadily decreases over time with regular payments.
If a loan has a longer amortization period—in other words, a longer amount of time to pay the loan off—the monthly payment will generally be lower because there’s more time to pay it off. But the total amount spent on interest might be higher over the course of the loan because you’ll need more time to pay off the principal balance.
How is a loan amortization calculated?
As you might assume, calculating a loan amortization schedule on your own can be tough. Luckily, there are shortcuts—such as online amortization calculators—that might help.
It’s important to remember that amortization calculations will vary based on variables like the type of loan, interest rate, loan amount and other details.
When you agree to a loan, many lenders will do the amortization calculations for you. But if you’re going the DIY route and using an online calculator, try to learn as many specifics as possible to get an accurate assessment. That means knowing things like:
- The annual interest rate
- The length of the loan, also known as the loan term
- The principal balance
It’s also helpful to account for any additional payments you might plan to make.
What’s a loan amortization schedule?
A loan amortization schedule shows borrowers how their loan payments will be divided between paying off the interest and principal over the set loan term.
The loan amortization schedule might be represented as a table or chart that shows the borrower how these amounts will change with every payment. That way, borrowers can see—month by month—what portion of their loan payment will go toward interest and what percentage will go toward the principal.
Why does loan amortization matter?
Loan amortization gives borrowers a clear snapshot of where their money is going with each payment—how much goes toward interest, how much goes toward the principal balance and how those percentages change over the life of a loan.
Learning how loan amortization works can help borrowers grasp the true cost of a loan over time. And that might help when it comes to making decisions about things like down payments, the loan term and more.
Loan amortization in a nutshell
Learning about loan amortization can help borrowers see how their loan payments are divided between interest and principal, and how that changes over time. And understanding how loans work can help people make well-informed decisions when it comes to managing their money.