Amortization has two contexts—one focused on business assets, and the other focused on loan repayments. When it comes to paying off loans, amortization is an important concept for consumers to understand.
What Is Amortization for Loans?
Consumers may recognize amortization best as a schedule of equal, periodic payments toward both the interest and principal balance of a loan. On those loans, the amortization schedule weighs interest payments on a loan much heavier in the early portion of the loan payoff period, with that interest declining throughout the life of the loan.
Let's say a high-net-worth individual has a mortgage of $1 million. If that individual repays $50,000 on an annual basis, then they are amortizing $50,000 of the loan every year.
How Does Loan Amortization Work?
Basically, amortization is a mechanism for paying down both the principal and interest on a loan via a series of fixed monthly payments. Lenders calculate amortization to the penny so that the loan is paid off accurately over the pre-agreed period of time. Accountants call that time period the "term" of the loan.
In this way, every loan payment is the exact same amount of money. Consider a 30-year mortgage loan of $165,000 with an interest rate of 4.5%. Since amortization refers to paying off a loan in equal, regular installments with a specific amount going to the principal and interest payments, the amortization schedule amounts to a total fixed monthly payment of $836.03 over the life of the mortgage loan.
On a monthly basis, over 30 years, that's what it takes in real monthly payment terms to repay the mortgage loan fully.
How to Calculate Loan Amortization
As amortization is the process of paying the same amount of money on (usually) a monthly basis, the calculation for doing so depends on the principal and interest owed on the loan. The goal is to make the interest payments decline over the life of the loan, while the principal amount paid on the loan grows.
Here's how to do so on a step-by-step basis:
Collect all of the information on the loan needed to calculate the loan amortization schedule. Basically, all you need is the term of the loan and the payment terms. Let's calculate the amortization rate on a monthly basis, like most mortgage or auto loans.
- Find the principal portion of the loan outstanding (let's say $100,000).
- Find the interest rate on the loan (let's say 6%).
- Find the term of the loan (let's say 360 months, or 30 years.)
- The monthly payment = $599.55
While the actual loan dollar amount is fixed, the amount you pay on a loan in terms of principal and interest is not. That's where a loan amortization schedule comes into play
To calculate amortization correctly and find the exact balance between principal and interest payments, multiply the original loan balance by the loan's periodic interest rate. The resulting figure will be the amount of interest due on a monthly payment. At this point, you can subtract the interest payment amount from the total amount of the loan to establish the part of the loan needed to pay down the principal.
Say, for example, that you have a mortgage loan of $240,000 over 360 months at an interest rate of 4%. Your initial monthly mortgage payment is $1,146. Your periodic interest rate stands at 0.33%, or one 12th of 4%.
Multiply $240,000 times 0.33%, and you'll find that the first interest rate payment on the mortgage loan is $792. Now, take the total monthly loan of $1,146 and subtract the interest amount of $792.00 That leaves you with $354 as the amount of the monthly loan repayment that will be steered toward the principal owed on the loan.
To calculate your amortization rate going forward, take the remaining loan principal balance amount ($240,000 – $354 = $239,646). Then multiply $239,646 by 0.33% to ascertain your next interest payment amount. Simply repeat the calculation to figure out amortization schedules right down the line on a monthly basis.
What Kinds of Loans Can Be Amortized?
Typically, amortization schedules are used for the following installment-based loans:
- Mortgage loan
- Auto loan
- Personal loan
- Student loan
- Business loan
Loans that cannot be amortized include home equity loans and any revolving debt or credit card debt, as those types of credit-based loans don't have fixed monthly payments.
Revolving debt and credit cards don't have the same features as an amortized loan, as they do not have set payment amounts or a fixed loan amount.
By and large, if your lender lets you know exactly how many payments you need to make to satisfy the loan and tells you that each monthly payment will be the same amount, it can be amortized. If the loan varies in the total amount owed on a month-by-month basis, it likely cannot be amortized.
3 Loan-Amortization Tips
To repay your amortized loans faster and get rid of the loan altogether, make these strategies an integral part of your loan-repayment plan:
1. Add Extra Dollars to Your Monthly Payment
If your total mortgage loan is $100,000 and your fixed monthly payment is $500, add $100 or more to each monthly mortgage payment to pay down the loan more quickly. Make sure to designate the payments as "payment toward principal" to your lender.
2. Make a Lump-Sum Payment
There's no law that says you have to spend a raise, bonus, or inheritance. Use the extra cash toward your total loan amount, and save on interest.
3. Make Bi-weekly Payments
Instead of paying once per month on a loan, pay half the monthly loan amount every two weeks. That way, you're making 13 months' worth of loan payments every 12 months, thus paying down the loan more quickly and saving big bucks on interest.