Chapter 3. What is amortization?
An amortized loan is a loan with scheduled, periodic payments that consist of both principal and interest. An amortized loan payment pays the relevant interest expense for the period before any principal is paid and reduced.
How to
To amortize a loan, it usually means establishing a series of equal monthly payments that will provide the lender with:
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- Interest based on each month's unpaid principal balance
- Principal repayment that will cause the unpaid principal balance to zero at the end of the loan
While the amount of each monthly payment is identical, the interest component of each payment will be decreasing and the principal component of each payment will be increasing during the life of the loan.
In other words, amortization is a mathematical calculation or a method for repaying a loan in equal installments. Part of each payment goes toward interest and any remainder is used to reduce the principal. As the balance of the loan is gradually reduced, a progressively larger portion of each payment goes toward reducing the principal.
The simple fact that you understand how amortization schedules work will help you make decisions to speed the pay at the beginning of the life of the mortgage and thus gaining momentum so you can reduce the overall cost of interest over the life of the loan. The next time you borrow a loan to buy a car or a house, take the time to understand your amortization schedule in addition to making sure your loan does not have an early repayment penalty that prevents you from saving on the total cost of your loan borrowing.
Practice
Now that you know how an amortization schedule works, find an application and run a few scenarios. Think of paying it forward and discuss your findings with a friend or a family member.
Congratulations! You can move on to Chapter 4. TVM impact on debts
To review the full module on Time value of money, click here.