Amortization
The process of spreading out a loan into a series of fixed payments over time.
Detailed Explanation
Amortization is an accounting technique used to periodically lower the book value of a loan or an intangible asset over a set period. In the context of a loan (like a mortgage or auto loan), amortization refers to the process of paying off the debt through regular principal and interest payments over time. In the early years of the loan, a larger portion of your payment goes toward interest, while in the later years, the majority of the payment pays down the principal.
The Formula
A = P [ r(1 + r)^n ] / [ (1 + r)^n - 1 ]
Where: A = Periodic Payment, P = Principal amount, r = Periodic interest rate, n = Total number of paymentsReal-World Example
If you take out a $300,000, 30-year fixed-rate mortgage at 5% interest, your monthly payment will be exactly $1,610.46. In month 1, $1,250 goes to interest and only $360.46 goes to principal. By month 360, almost the entire $1,610.46 goes directly to the principal.
Key Takeaways
- •Amortization schedules show exactly how much of your payment goes to interest vs. principal.
- •Early loan payments are primarily interest, while later payments are primarily principal.
- •Making extra principal payments early in the loan drastically reduces the total interest paid.