What Is An Amortization Schedule?
Amortization is defined as a method of periodically lowering the book value of a loan over time. As a loan is paid off in installments, the current balance decreases, and this is shown in an amortization schedule. So, what exactly is an amortization schedule?
Simply put, this is a table displaying regularly scheduled payments of a loan, and how they lower the outstanding principal and loan balance over time. The schedule will usually show you the monthly repayment breakdown of the loan's outstanding balance for the agreed term, including the principal and the interest.
While the monthly payments you make might seem the same, the components of each of these payments change over time as the loan is repaid. Early on in the schedule, the majority of each payment consists of interest, while later payments will consist mostly of the principal.
When Is It Used?
Generally speaking, if a lender lets you know exactly how many payments you need to make to pay off a loan, and assures you that each monthly payment will be the same amount, it can be amortized. If the monthly payments change, an amortization schedule is unlikely to be used.
Typically, amortization schedules are used for installment loans, including:
For instance, if you have a 30-year mortgage loan of $165,000 at an interest rate of 4.5%, the first few months will show a higher interest vs principal, with the opposite being true later on in the schedule. Alongside this report of the varying payment breakdowns from month to month, you will still see a fixed monthly repayment of $836.03.
How Does It Work?
Lenders provide this schedule alongside the loan contract. You can also use an online calculator to get a rough estimate of what you will be paying over the life of the loan. If you know the loan’s term and rate of interest, it can help you with the following:
- Understand how much you will be paying each month on the loan
- Determine how much extra you can pay each month to clear it off before the term
- Learn how much interest you have paid and will be paying until the total outstanding is zero
Every amortization schedule will have almost the same kind of information. Usually, the schedule will show Scheduled Payments, Principal Repayments, and Interest Charges.
Here is how you calculate amortization:
- To measure amortization accurately, determine the exact balances of the principal and the interest payments
- Multiply the initial loan balance by the annual interest rate of the loan. The resulting balance would be the rate of interest due on a monthly bill
- Next, deduct the amount of the interest payment from the overall sum of the loan to calculate the portion of the loan required to pay off the principal
For instance, if you have a loan of $50,000 for 5 years at a 4% rate starting from July, 2020. Your first month’s payment will be $921. Thus, your periodic rate of interest stands at 0.33%, i,e. One-twelfth (1/12) of 4%. Based on this calculation, your amortization schedule will look like the figures presented in the table below.
Pros vs Cons Of DIfferent Length Amortization Schedules
Short-term and long-term loans and their respective schedules each have their perks and drawbacks, which you must assess to determine which one suits you better.