What is amortization? (with photos)

The process of repaying a loan through specifically structured periodic payments is known as amortization. This type of credit differs from the others in the way in which the amount and structure of each payment are determined.

Monthly mortgage payments are a common type of amortization.

Mortgage payments are a common form of amortizing loans and, interestingly, the terms “mortgage” and “amortization” find their meaning in the same root word: “mort”. This term means to cushion or kill, like “kill” or eliminate the loan a little at a time, through regular payments. As far as home loans are concerned, payments are normally the same every month with a fixed interest rate. In some cases, the last payment may be slightly higher or lower than payments made over the life of the loan.

Repaying a loan through specifically structured periodic payments is known as amortization.

Amortized payments are calculated by dividing the principal – the balance of the amount borrowed after payment – ​​by the number of months allotted for repayment. Then interest is added. Interest is calculated at the current rate for the duration of the loan, usually 15, 20 or 30 years. Each payment eliminates first a percentage of the interest and then a portion of the principal.

Some people confuse these loans with interest-only loans. On an interest-only loan, the full amount of the scheduled payment goes towards the interest due on the loan, not the principal. Borrowers may, however, make specific additional principal payments. These loans can be beneficial because they usually allow for smaller payments. With an amortized loan, it is true that most of the payment goes towards interest – at least at the beginning of the loan – but some of the principal is actually paid off as well.

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In most of this type of loan structure, it can take at least half the life of the loan or longer for the interest and principal payment amounts to equalize. Eventually, the principal amount to be paid begins to exceed the interest amount, depleting the balance more quickly.

Many people choose to pay an additional amount each month and apply that amount to their principal balance. Since interest is the product of the principal multiplied by the interest rate, the lower the principal, the lower the interest payment. Making additional or larger payments each month helps save money in the long run and shortens the life of the loan. It is important that borrowers make it clear to the finance company that the additional amount must be applied directly to the principal.

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