Amortization: What It Is and Why It Matters

Written by: Cash101 Staff

Amortization is a financial process where you take a loan and spread it out into fixed payments that come in over a longer amount of time. Here’s a little information on what this is and how it works.

Overview

Each payment includes money that goes towards paying off a loan’s interest as well as money that goes towards paying off the principal, or the amount of the initial loan. The total amount of your payment will still stay static under this system while all of this is calculated as you go. Amortization is the standard way to handle loans, generally speaking.

The way that the process usually works is that you pay a bit of interest and a bit of principal on a monthly basis. This doesn’t have to be the case though, since you can instead calculate it in different ways or do different things with it such as paying off a loan on an asset that’s more intangible over the course of its life.

Types of Loans

This process can apply to just about any loan, but some of the major ones that tend to use it include home loans and auto loans. With these types of loans especially, the costs you pay in interest tend to be the highest right at the beginning of paying off the loan. Since the amount you pay is the same every month, what happens is that you pay off interest mostly at first, and then as the principal lowers and the interest goes down because it’s drawing from a smaller amount, you pay off more and more principal.

As a result, you pay less interest in terms of the percentage of the monthly payment. Thi sis by design the idea is to pay it all off within a certain amount of time. This is important when considering amortization costs. The tendency from those getting a loan is to focus what kind of loan they get based on the total cost and what they would consider to be “affordable.” The issue is that when you make the payment lower, you end up paying a lot more in interest.

So, there’s definitely a tradeoff here between how big you want the payment to be in general and how much interest you want to pay in the long run. It’s up to you to choose.

Auto loans are usually only 5 years or shorter. You get a fixed monthly payment here. Some people focus only on the monthly payment without thinking of any other possibility at all. You actually have the choice to get a loan for even more time if you so choose, but this has some problems with it. For example, if you do it this way there’s the possibility that your loan could be for much more than the resale value of your car.

This is due to the fact that car’s tend to depreciate in value rather quickly.

In the case of home loans, you generally go for 15 or even 30-year mortgages on the loan. These also tend to be a fixed rate. It’s actually possible to refinance the loan, but the loans work as if you were going to pay them off in the normal way every time.

There are other types of loans that don’t use the amortizing principle. These include credit card loans, for example. You can keep charging the card, essentially getting a new loan every time, and all that matters is what the final balance is at the end of the month. Another type of loan that isn’t under this banner is where it’s interest only. This means that you pay only interest for a while, and not any principal at all. The only way to pay down the principal during the part where you pay only interest is to add in extra payments. There’s also something called a balloon loan where you don’t pay most of the principal until towards the end of the time where you’re paying off the loan. You pay a big payment on the principal right at the end, but you don’t pay nearly as much in the early years since you’re mostly just paying a little bit here and there.

Strategies

There’s a lot of different strategies you can take to the amortization process depending on your situation. For example, you can add a little extra to your fixed payments when you can in order to pay the loan back faster and end up with paying less interest overall.

In other words, you can set your fixed payment at something that you know you can afford, but end up paying less interest overall anyway, even to the tune of thousands upon thousands of dollars if you just add an extra hundred dollars here or there in order to pay it off a bit faster. Remember, the quicker you get through that interest and that principal, the less interest you’re going to pay overall, even if your fixed payments are at a certain rate.

Another approach you can try is just sending in lump sum payments. Obviously, you’re going to have to check with the loan to make sure that you’re allowed to do this, but many will let you. By paying a large lump sum payment, you again bring that principal down directly once you get passed most of the initial interest. If you end up with a little extra cash for whatever reason.

Depending on the situation, you can pay biweekly instead of monthly in order to help with some loans depending on the situation as well.

Overall, it makes a lot of sense to make sure that you fully understand amortization due to the fact that it’s such a common process that happens in many of the most important loans that you’ll make throughout your life. It would be dangerous not to understand it as much as you can.


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Amortization: What It Is and Why It Matters

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