What Is Loan Amortization And How Does It Work?

If you’ve ever applied for a loan, you might have heard your lender use the term “amortization.” But what does it mean and why is it important? Loan amortization is the process of paying back the money you’ve borrowed in set increments. An amortization schedule is a visual breakdown of all your monthly payments, and you can calculate it by hand or with a loan calculator.

Let’s take a closer look at what amortization is and how you can use it to determine your minimum monthly payment and total interest on a loan.

The broader term “amortization” refers to the systematic reduction of an intangible asset’s book value over a set period of time. When amortization is used in connection with a loan, it refers to the process of repaying the amount borrowed in fixed installments.

Each time you make a monthly payment on your loan, part of the total is applied to your interest while the remainder goes to your principal (although a portion of your payment on a mortgage will likely go to homeowners insurance and property taxes). As you make more monthly installments, a larger portion of your payment each month will go toward the principal, until your loan is repaid in full.

Positive Amortization Vs. Negative Amortization

You may also hear the term “negative amortization” mentioned in regard to some types of financing. Negative amortization occurs whenever the minimum payment for a loan doesn’t decrease the amount the borrower owes.

For example, if you made the minimum payment on your credit card’s outstanding balance, the amount you owe might not shrink if the payment didn’t cover the full interest charge for the month. That’s why many financial experts suggest making larger payments to get out of credit card debt.

Loan amortization works by dividing your loan’s principal balance into equal, incremental payments that you’ll make on a fixed schedule, typically on a monthly basis. An amortization schedule allows you to see how much of your principal and interest change with each payment by using a table to showcase your beginning and ending balances.

Your schedule will be determined by your loan amount, repayment term and interest rate. And, the type of loan you’re using can impact all three of these factors. Up next, we’ll see how the term of each of the following loan types affects amortization.

Personal Loans

A personal loan is usually an unsecured loan that a borrower can use for a variety of reasons, including debt consolidation, funding home improvements or covering last-minute expenses. Personal loan repayment terms range from 12 – 60 months and interest rates can be anywhere from 4% – 36%.

Since personal loans vary widely in their rates and terms, your loan’s amortization schedule will depend on your specific circumstances. Of course, having a higher credit score can help you land a lower interest rate, which will reduce the amount of interest you’ll pay up until the loan is paid in full.

Fixed-Rate Mortgages

Both primary and secondary fixed-rate mortgages use amortization to pay off the loan balance the homeowner has borrowed. Different types of home loans carry different rates and terms that could affect your amortization schedule.

However, unlike personal loans, most mortgages require a down payment. Lenders use the dollar amount of a down payment to help determine a borrower’s interest rate. A larger down payment will shrink your loan balance and in all probability reduce your interest rate, creating a smaller monthly payment.

Auto Loans

Auto loans are similar to mortgages, although with a much smaller loan amount. Both are secured loans that use the item you’re buying as collateral, and both may require a down payment. The dollar amount of the item you’re purchasing will affect the amortization and monthly payment of your loan.

You can reduce your car loan’s monthly payment by making a larger down payment, getting a longer term or both. But keep in mind that the longer your repayment period, the more interest you’ll pay in time. For example, a 72-month auto loan will require more interest than a 60-month loan.

Now that you know what factors can affect your amortization schedule, let’s take a deeper dive into how to make your own table. Of course, you can choose to use an amortization schedule template in a spreadsheet or an online calculator to help with this process.

However, using this formula could help you better understand how to find the best monthly payment for your budget. Here’s the equation you can use to find your monthly payment on an amortized loan.

Monthly Payment = P ((r (1+r)ⁿ) ∕ ((1+r)ⁿ−1))

To use this equation, you’ll need to know the following about your loan:

• P: This variable represents the total amount of money you’ve borrowed.
• n: This component is the total number of payments you’ll have to make on the loan. You can calculate this by multiplying your number of payments per year by the number of years in the loan term.
• r: This letter represents your monthly interest rate. You can find this by dividing your annual percentage rate (APR) by the number of payments you’ll make in a year.

Example Of Amortization: Creating A Table Step-By-Step

Let’s consider an example amortization table. You have a personal loan of $20,000. Your APR is 8% and the repayment period is 3 years. “P” will be $20,000, “n” is 36 (3 × 12 months) and “r” is 0.00667 (8% ∕ 12 months).

1. Find Your Monthly Loan Payment Amount

First, fill out the equation with the information provided above. You should get:

P = $20,000 ((0.00667 (1+0.00667)³⁶) ∕ ((1+0.00667)³⁶−1))

Now you can solve the equation using the PEMDAS method. First, complete the expressions in the parentheses, then the exponents. From there, you’ll divide and multiply to find your monthly payment, which should come out to:

P = $626.73

2. Determine Your Interest And Principal Amounts

With the monthly payment calculated, you can now figure out how much you’ll spend in interest by multiplying the loan amount by your APR:

$20,000 × 8% = $1,600

Then, divide this total by the number of monthly payments in a year to find the amount of interest:

$1,600 ∕ 12 = $133.33

Next, take this total and subtract it from your monthly payment to find how much will go toward the principal amount:

$626.73 − $133.33 = $493.40

3. Fill Out Your Amortization Table

You can make an amortization schedule for your loan using the above information. Here’s the first year of payments:

To calculate the remaining months, you would use the previous month’s ending balance instead of your original loan amount:

$19,506.61 × 8% = $1,560.53

Again, divide this amount by the number of monthly payments in a year to find your interest payment:

$1,560.53 ∕ 12 = $130.04

Then, subtract this total from your monthly payment amount to find your new loan principal payment:

$626.73 − $130.04 = $496.69

You can keep repeating this final step to fill out the table for your remaining payments.

Understanding what amortization is and how it works for different types of loans can help you find the right financing option for your budget. If you can calculate the total amount of interest you’ll pay for a loan, you’ll understand the cost of borrowing money from a specific lender.

If you’re interested in applying for a personal loan and want to know the rates and terms you could prequalify for, get started today with Rocket Loans^SM.