Apr 7 2018

How Amortization Works: Examples and Explanation, loan modifications.#Loan #modifications

How Amortization Works

Loan modifications

Amortization is the process of paying off a balance over time with regular, equal payments. This is most common with monthly payments on loans, but amortization is an accounting term that can apply to other types of balances.

With loans, including home loans and auto loans, each monthly payment looks the same, but the payment is made up of several parts that change over time. A portion of each payment goes towards:

  1. The interest costs (what your lender gets paid for the loan).
  2. Reducing your loan balance (also known as paying off the loan principal).

At the beginning of the loan, interest costs are at their highest. Especially with long-term loans, the majority of each periodic payment is an interest expense, and you only pay off a small portion of the balance. In other words, you don’t make much progress on debt repayment during the early years.

As time goes on, more and more of each payment goes towards your principal (and you pay less in interest each month).

Amortized loans are designed to completely pay off the loan balance over a certain amount of time. Your last loan payment will pay off the final amount remaining on your debt. For example, after exactly 30 years (or 360 monthly payments) you’ll pay off a 30-year mortgage.

Your monthly loan payments don’t change — the math simply works out so that the debt is eliminated.

Amortization in Action

Sometimes it’s helpful to see the numbers instead of reading about the process. Scroll to the bottom of this page to see an example of an auto loan being amortized. The table below is known as an amortization table (or amortization schedule), and these tables help you understand how each payment affects the loan, how much you pay in interest, and how much you owe on the loan at any given time.

Sample Amortization Table

The table below shows the amortization schedule for the beginning and end of an auto loan. This is a $20,000 five-year loan charging 5% interest (with monthly payments).

To see the full schedule or create your own table, use a loan amortization calculator.

Looking at amortization is extremely helpful if you want to understand how borrowing works.

True cost of borrowing: With a detailed picture of your loan’s components, you can clearly see how much you really pay in interest – instead of focusing on a monthly payment. Consumers often make decisions based on an “affordable” monthly payment, but interest costs are a better way to measure the real cost of what you buy. Sometimes a lower monthly payment actually means you’ll pay more in interest (if you stretch out the repayment time, for example).

Decision making: You can also decide which loan to choose when lenders offer different terms (how much could you save with a lower interest rate?). You can even calculate how much you’d save by paying off debt early – you’ll get to skip all of the remaining interest charges on most loans.

To visualize amortization, picture a chart (your loan balance is the vertical X axis and time is the horizontal Y axis) with a line going down and to the right. With shorter-term loans, the line is more or less straight. With longer-term loans, the line gets steeper as time goes on.

How to Amortize Loans: Calculations

There are several ways to get amortization tables (like the one above) for your loans:

  1. Build your own table by hand.
  2. Use an online calculator, which will create the table for you.
  3. Use spreadsheets to create amortization schedules and help you analyze loans.

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Online calculators and spreadsheets are often easiest to work with, and you can often copy and paste the output of an online calculator into a spreadsheet if you prefer not to build the whole model from scratch.

The monthly payment: With an amortizing loan, figuring out the payment is just math. The payment is based on the amount of the loan, the interest rate, and how many years the loan lasts. Those three ingredients work together to affect how much you pay each month and how much total interest you’ll pay.

Lowering the interest rate can lower your payment, and it helps you save money. Stretching out the loan over a longer period of time will also lower your payment, but you’ll end up paying morein interest over the life of the loan.

To amortize a loan, use the table above as an example, and complete the following steps:

  1. Note your starting loan balance: $20,000
  2. Figure out the payment (calculation shown on this page): $377.42
  3. Figure out the interest charge for each period – usually monthly (calculation shown on this page): $83.33 in the first month
  4. Subtract the interest charge from your payment – the remainder is the amount of principal you ll pay that month: $294.09 in the first month
  5. Reduce the loan balance by the amount of principal you ve paid: you owe $19,705.91 after your first payment
  6. Start over with the following month: $19,705.91 is the loan balance in the second month

Types of Amortizing Loans

There are numerous types of loans available, and they don’t all work the same way. Any installment loan is a loan that amortizes: you pay the balance down to zero over time with level payments.

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