What is Amortization

Understanding What is Amortization and the Terms Related to It

Before planning to take a loan and its repayment scheme, you should understand what amortization is and what are its benefits.
WealthHow Staff
Last Updated: Jun 3, 2018
Amortization is the process of paying off a loan with the help of structured and periodic installments. It provides a way to reduce one's obligations, by allowing him to make monthly payments against his loan or debt. Mortgage payments are a common form of amortized loans and help the borrowers to repay the loan with a fixed interest rate, and over a certain period of time. These payments are calculated by dividing the principal amount with the number of months allotted for repayment. This principal amount is the balance left after making a down payment for the loan. After that, the rate of interest, which is calculated at the current rate and according to the loan repayment term, is taken into consideration.

From each installment of repayment, a percentage is put aside for the interest, and then the amount left is subtracted from the principal amount of the loan. Because of that, many people try to pay some additional amount each month and apply it to the principal balance. Since the amount of money to be given as interest is dependent on the principal amount, lower principal will result in lower amounts of interest. These monthly additional payments help to save money in the long run and also to reduce the time span of the loan.

When the debt incurred by the borrower is large, most of the lending institutions disburse the loan, allowing the borrower to repay in installments over a definite period of time. It is sometimes confused with the concept of depreciation. In case of depreciation, the cost of a tangible asset over its useful life is considered, whereas, amortization deals with intangible assets, like mortgage.

Terms
Here a few terms which are related to amortization and are helpful for planning and keeping a track of the loan repayment scheme for the borrowers.
  • Amortization Chart: This charts keep a record of the loan repayment and shows the amount subtracted from the principal as and when the monthly installments are paid. They are also commonly referred to as amortization tables or schedule, and are important, as one tends to get confused by the formulas used in the calculations.
  • Excel Loan Spreadsheet: This spreadsheet provides the borrowers with a template which, in turn, helps them to create a loan repayment schedule. This spreadsheet creates a schedule for the fixed-rate loan with optional extra payments, which can be paid annually, semi-annually, quarterly, bi-monthly, or monthly.
  • Calculation Formula: A formula is a useful tool that determines the amount to be paid, monthly, in case of amortized loans. It can also be used to find out the exact amount that goes towards interest and the amount which is subtracted from the principal, after each repayment. The formula used to calculate the periodic payment amount is:
    A=(P*r (1+r)n)/ ((1+r)n -1))
    where,
    A= the amount to be paid periodically
    P= Principal amount
    n= total number of payments (for 15 years, total number of monthly payments will be (15*12) = 180)
    r= the rate of interest
Nowadays, lending institutions provide loans to purchase homes, run businesses, buy a car, and other major items. But, before deciding upon a loan, one should always try to perform the necessary calculations and look out for the best possible repayment plan.

Disclaimer: This article is for reference purposes only and does not directly recommend any specific financial course of action.