Amortization of a loan is the gradual reduction of the debt over a fixed period of time.
It is a term commonly applied to mortgages, but can also apply to any type of loan that is being repaid in such a way that the interest is covered and the principal amount is reduced over time.
Amortization in Action
When you take out a loan you will typically be given a repayment schedule for the full duration of the agreement. Each installment that is due will include the interest as per the Annual Percentage Rate (APR) and a portion of the principal (amount borrowed).
This means that over a fixed period of time the amount owed will be reduced until the loan is fully repaid.
This process is called amortization.
In cases where repayments are missed or rare cases where lenders allow the borrower to repay only the principal for a period of time, the overall amount owed can increase due to the outstanding interest. This is called negative amortization or NegAm.
NegAm is most commonly seen with mortgages in which the lender requires payment in full by a given date, but accepts partial payments lower than the amount of interest accrued in the meantime.
Virtually any loan that is repaid in installments is 'amortized'.
Credit cards on the other hand are not always amortized, as it is you who decides how much to pay each month. If you do not pay the full balance for one month, you are charged interest the following month.
If you keep using the card and not paying the full balance the overall debt will also increase. Furthermore, other than the desired 'minimum', there is no set repayment schedule.
Although most lenders provide a repayment schedule with their loans and ensure amortization takes place by requiring payments that are high enough to do so, there are times when you might want to calculate amortization yourself.
This is easily done be using one of the many online calculators that allow you to input the principal amount, interest rate and the duration of the loan.
A summary will then be returned including calculations like how much each monthly payment will be, the total number of payments that will need to be made, how much is paid in interest, and other helpful data.
When you first take out a loan the amount of interest you pay is at its highest. This is more noticeable with long-term loans, where most of the early repayments are used to cover the interest and only a small percentage of the principal is paid down.
Over time a higher percentage of each repayment goes towards the principal and less goes towards the interest. By the end of the fixed period and your last payment, the entire principal and interest will have been covered.
A schedule outlines the amount of interest and principal paid for each installment.
For example in month one of a $20,000 loan, that is to be repaid over 5 years at 5% interest, you will be paying $377.42 - $294.09 goes towards the principal and $83.33 to interest. Then by payment 60 $374.29 is allocated to the principal and only $1.57 is interest.
Each month is broken down with a schedule.
Why It's Important
Grasping how it works is important for understanding borrowing as a whole. It offers a clear way of seeing how much interest you are really paying, instead of just knowing the monthly total repayment amount.
In turn this arms you for comparing different loan packages from different lenders, in terms of how much you could save on interest.
Furthermore you can use it to calculate the amount you would save on interest by repaying the loan early (if your lender permits this) - as you only pay interest on an outstanding balance.
Amortization in Accounting
A form of amortization is also often used for tangible assets (otherwise known as depreciation) and natural resources (depletion). Businesses tie the costs of these assets with the revenue they generate, offsetting the expense over several years. For example a company might purchase a printing machine for $15,000. Over time this machine will generate revenue which offsets the expense.
Particularly large expenses are often amortized over several years to give a better picture of the company's financial situation. For example if company A purchased an asset for $200,000 and accounted for it in a single financial year, it would have a large dent on their reported profit.
By spreading the expense over several years (often tied to its revenue generation), it levels out their tax liability and gives a more consistent picture of their profitability.
Both types, payday loans and amortized loans are a common and effective tool for borrowers and lenders. By understanding this process borrowers can also ensure they find the best package and know exactly how much is to be repaid.