Amortization
Amortization is the process of spreading loan payments over time in regular installments, with each payment covering both principal and interest, gradually reducing the loan balance to zero.
Exam Tip
Early payments are mostly interest, later payments are mostly principal. Know the amortization schedule concept.
What is Amortization?
Amortization is the process of paying off a debt over time through regular, equal payments. Each payment includes both principal (the loan amount) and interest, structured so the loan is fully paid off by the end of the term.
How Amortization Works
In the early years of an amortized loan, most of each payment goes toward interest. Over time, as the principal balance decreases, more of each payment goes toward principal.
Amortization Schedule Example
| Payment | Principal | Interest | Remaining Balance |
|---|---|---|---|
| 1 | $200 | $800 | $99,800 |
| 60 | $350 | $650 | $85,000 |
| 120 | $550 | $450 | $65,000 |
| 360 (final) | $990 | $10 | $0 |
Key Formulas
Monthly Payment Formula:
M = P × [r(1+r)^n] / [(1+r)^n - 1]
Where:
- M = Monthly payment
- P = Principal (loan amount)
- r = Monthly interest rate (annual rate ÷ 12)
- n = Total number of payments
Types of Amortization
| Type | Description |
|---|---|
| Fully Amortizing | Standard loan paid off completely by term end |
| Partially Amortizing | Balloon payment due at end |
| Negative Amortization | Payments don't cover interest; balance grows |
| Self-Amortizing | Includes both principal and interest |
Amortization in Real Estate
Most home mortgages use amortization:
- 30-year fixed: 360 monthly payments
- 15-year fixed: 180 monthly payments
- Front-loaded interest: Early years pay mostly interest
Amortization vs. Depreciation
| Amortization | Depreciation |
|---|---|
| Intangible assets or loans | Tangible assets |
| Paying off debt | Allocating asset cost |
| Examples: mortgages, patents | Examples: buildings, equipment |
Impact of Extra Payments
Making extra principal payments:
- Reduces total interest paid
- Shortens loan term
- Builds equity faster