Understanding Amortization Calculation
Amortization is the process of gradually paying off a loan over time through regular payments, which cover both the interest on the outstanding balance and a portion of the principal.
1. Monthly Payments
Each loan payment includes:
- Interest: The cost of borrowing, calculated on the remaining loan balance.
- Principal: A portion of the original loan amount, which reduces the balance.
The objective is to have each payment reduce the balance gradually until the loan is fully repaid by the end of the term.
2. Amortization Formula
The monthly payment is calculated using this formula:
Where:
- M: Monthly payment
- P: Loan amount (principal)
- r: Monthly interest rate (annual interest rate divided by 12)
- n: Total number of payments (loan term in years × 12)
3. Monthly Payment Breakdown
Each monthly payment covers interest and principal:
- Interest: Calculated based on the remaining balance.
- Principal: The remainder of the payment, which reduces the balance.
Over time, more of each payment goes toward the principal, reducing the balance faster.
4. Amortization Schedule
An amortization schedule is a table showing how each payment affects the balance over time. Here’s an example:
| Payment # | Principal Paid | Interest Paid | Remaining Balance |
|---|---|---|---|
| 1 | $200 | $300 | $9,800 |
| 2 | $205 | $295 | $9,595 |
| 3 | $210 | $290 | $9,385 |
| … | … | … | … |
| Final | Full | Small | $0 |
5. Total Cost of the Loan
The total cost of the loan includes:
- Principal: The original amount borrowed.
- Interest: Accumulated interest over the term.
For long-term loans, interest can make up a significant portion of the total cost because of the length of the loan term.