The term Amortize means to gradually reduce, or pay off, a debt over time. For fully-amortized loans like car loans, most mortgages, and other forms of installment loans, the regular payments that you make each month will eventually lead to a paid off loan.
An Amortization Schedule is the financial tool that displays these projected principal and interest payments and the corresponding annual loan balance forecast over the life of the loan. This is very useful for comparing mortgage products, interest rates, and loan terms.
For most traditional fixed rate loans, amortization is easy to model. You’ll be making the same regular payment each month, and the amortization schedule will show the projected decline in the loan balance.
As the loan balance drops, so do the interest charges. Consequently, more and more of your regular monthly payment will go to pay principal instead of interest. For this reason, the loan balance tends to drop faster in the later years of the loan.
Let’s look at an example using the following assumptions:
- $100,000 beginning balance,
- 5% annual interest rate, and
- 20-year financing term
The regular payment (principal and interest only) for this loan is approximately $660 per month or $8,000 per year. The first-year interest is approximately $5,000 (5% of the loan balance). That means that approximately $3,000 was applied to principal in year 1.
The chart shows the consistent payment of $8,000 each year. But notice how the composition of the payments changes over time as the balance drops.
Because the amount applied to principal increases over time, the loan balance will drop in a gently downward sloping curve as shown below. At year 20, the loan balance is $0.
For adjustable rate loans, the payments may not be so predictable. Payments will fluctuate as higher interest rates, for example, will require higher payments to stay on schedule.
For interest-only loans, the borrower will only pay the interest portion for a specified time period. In the above example, that would be $5,000 annually ($417 per month). If no additional payments are applied, the loan balance will remain flat during the interest-only period.
For reverse mortgages, the borrower is not required to make any principal and interest mortgage payments so long as the mortgage is in good standing. As a result, the loan balance will rise unless periodic voluntary prepayments are made.