How Amortization Works
What a word! It sounds like it should be up there with death and taxes.
Fear not. It is just the word to describe how the initial loan amount you take gets paid back over a period of time. The initial loan amount is usually called the principal.
Each payment is split into two parts—interest and principal. You’ll pay the interest due for that period, and the rest will go towards paying down the principal.
Since the principal balance is lowered with each payment, the interest due will decrease with each payment, creating a snowball effect. Therefore, as principal decreases, more of your payment each month will go towards principal instead of interest.
Here’s an example of how amortizing (paying down) a loan of $100 at a 10% annual interest rate would work.
The amount in blue is the amortized principal payments – i.e., the amount of the loan you will pay back each month.
This principal paid increases over time because you are decreasing the balance (the amount of money you still owe) with each payment.
Since the interest rate is set at 10% annually, the amount of interest paid will decrease as your balance decreases—leaving more of the payment to go to principal.
Finance uses many terms which we do not typically use in day-to-day life. Most, however, are old terms that have been around for centuries, and the finance world hasn’t moved on from them as we have.
Whenever you see a confusing finance term, it’s usually pretty straightforward, just using a strange name.
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