Amortization
By
David Pilley on August 30, 2010
If you’ve taken out a large loan, chances are you won’t be able to pay it all back in one lump-sum. This is true for most people with a student loan, and this is also true for about 99.9% of people with a mortgage loan. Therefore, you will be paying back the loan on a schedule.
Amortization is the repayment of a loan on a schedule, almost always a monthly schedule. Not only do you pay a portion of the loan each month, you pay the
same amount of the loan each month. Unlike other repayment models, in an amortization payment plan each payment consists of both principal and interest. Because the payment you make every month is the same, amortization is the simplest repayment plan and one of the more popular types of plan. (One constant number is easier to keep track of than a constantly growing number, after all.)
Since the payment you make each month is constant, that means there is a formula involved to create this number. Here is this formula:
P = A* 1-(1/[1+r])n
r
“P” = the principal amount owed, “A” = the periodic payment, “r” = the interest rate divided by 100 (this number is also divided by 12 if you make monthly payments), and “n” = the total number of payments.
There are online mortgage calculators you can use to calculate your monthly payment, if you don’t like doing it longhand. I assure you they use this same formula, but another handy piece of information they supply is the
amortization schedule. This schedule actually shows how much of each payment is toward the principal and how much is toward interest. It is important to note that your first payment will consist mostly of interest. The more payments you make, the more it goes toward paying off the principal. For example, if I were to take out a 30-year, $200,000 mortgage loan today with a 7% interest rate, each monthly payment would be
$1,330.60. However, my first monthly payment (in Sept. 2010) would be
$1,166.67 toward interest and
$163.94 toward the $200,000 principal. As you make more payments, the amount toward interest decreases and the amount toward the principal increases. So, a payment in Mar. 2026 would consist of $846.97 toward interest and $483.64 toward the principal. With this
online mortgage calculator, you can also see how the schedule will be affected if you add to your monthly payments. (Hint: If you can pay more than the monthly payment for even
one month, the total amount you have to pay will drop.)
It is crucial that you are able to make each monthly payment,
especially at the beginning of your payment plan. If you are short,
negative amortization would occur. In this situation, the amount you are
short of the interest will be added to the total amount owed, and you will ultimately owe much more. Because you pay more toward interest at the beginning, you will be penalized much more if you are short a payment in the first few months of your amortization plan.