What is Amortization?

Loans, whether it be a mortgage, auto loan, or personal loan, all follow a basic structure. But as a borrower, you may be wondering how exactly your monthly payments are calculated. If you look ahead to your payment schedules, you may ask why you're paying more than what you initially applied to borrow. The process that details this is known as amortization.

In this blog, we'll take a closer look at amortization, as well as the different types and how it can be calculated.

What Exactly is Amortization?

Amortization is defined as "the action or process of gradually writing off the initial cost of an asset." When you look at this in the framework of a loan, amortization is essentially the process of you paying off the loan over time. As you make payments each month on your home, car, or any other borrowed asset, the cost to borrow that item is amortizing.

Whether or not you realized it at the time, your lender likely reviewed your loan's amortization during the application and approval process. They may have shown you a chart or a table that outlined how your total loan amount would decrease month over month, and how your payments were applied to the principal and interest totals.

How Loans Work

Before diving deeper into amortization, let’s review exactly how loans work. You’ll start by applying for a loan and will need to share specific documents (like recent paystubs, your W-2s, etc.) with your lender. If and when you’re approved, your lender will review your terms, including your interest rate, annual percentage rate (APR), and monthly payment.

The term for your loan is the amount of time you have to pay off the borrowed funds, plus interest—this is what it means when someone says their mortgage is a 30-year mortgage, for example. Over those 30 years, you'll make a monthly payment to pay off your loan's balance.

When a loan is amortized, it means that you'll pay more interest at the beginning of your loan, and less towards the end. This is why you may often hear people say to put payments for their loan balance towards the principal. In the long run, it will help to cut down on how much interest is paid.

Principal vs. Interest

When you're talking about loans, two terms that are sure to come up are principal and interest. While both deal with the money you're borrowing, they're quite different. The principal is strictly the amount of money you're seeking to borrow for a given purchase. If the car you want to buy costs $12,000, that amount would be the principal amount.

Interest is the amount of money your lender charges you for borrowing funds. It's often called the "cost" for borrowing money. Interest is determined as a percentage of the total amount of money you're borrowing. The lender can often use interest to cover losses in the event the loan balance is not paid off.

Amortization vs. Depreciation

You may be thinking amortization sounds a lot like depreciation. Both refer to an initial cost decreasing over time. But the two terms are tied to different types of assets. Amortization refers to intangible assets, while depreciation refers to tangible assets.

Intangible assets are things that you can't physically touch or see. A loan balance or computer software are examples of an intangible asset. Tangible assets refer to the exact opposite—objects you can physically see or touch. Cars, homes, and furniture would be good examples of tangible assets.

Amortization and depreciation both operate independently of the other. For example, if you had an auto loan, your car is what depreciates in value once you drive it off the lot (and continues to do so over time). Your loan is what will amortize over time as you continue to make your monthly payments.

Different Types of Amortization

There are different types of amortizations that accountants and other financial professionals use. Here are some of the most common:

• Straight line: measures the cost of an intangible asset against expense over a consistent time. Straight line amortization is used to analyze things like patents.
• Declining balance: used to measure the amortization of items that depreciate, or lose value, early on and continually over time. Cars and technology would be assets where declining balance amortization would be used.

• Negative amortization: if you notice your loan balance increasing after making a payment, you are likely to see negative amortization. Some lenders may offer you the choice to make a minimum payment that won't end up covering the interest you owe. This is a slippery slope, and one you should avoid if possible.

How is Amortization Calculated?

If you want to calculate the amortization of your loan, there's a basic formula you can follow. Let's take a closer look with this example using the declining balance method: Let's say you have an auto loan for $20,000 with 6.1% annual interest, and a monthly payment of $360.

1. Start by multiplying the current balance ($20,000) by the quotient (answer) of the interest rate over 12 (for the 12 months of a year). Your interest rate would be .061 for the purpose of this formula. This will define your monthly interest, with the answer being $101.67.
   

2. Now, take this monthly interest ($101.67) and subtract it from your monthly payment ($360). The answer is $258.33, known as your principal reduction.

3. Finally, subtract your principal reduction ($258.33) from the initial balance ($20,000). This gives you $19,741.67.

That ultimate answer, $19,741.67, is how much you'll still owe towards your auto loan after one month of payment. You may be asking yourself: "If I paid $360, why is my balance still above that difference from $20,000?" That is where interest and amortization come into play.

Why Amortization Matters

At first glance, amortization may just sound like a fancy term that accountants and loan officers need to understand. However, if you have a base understanding of this topic as a consumer, you could potentially save yourself money in the long run. It helps to have a general understanding of amortization because:

• You’ll have a full picture of the cost of borrowing: Amortization lays out your loan terms and how much interest you'll pay—it goes beyond just the sticker price of an item.
• An amortized loan sets your monthly payment: If your loan is 3 years in comparison to 4 or 5, you'll have a higher monthly payment but will pay less in interest.
• You can avoid overpaying with your loan: Having awareness of amortization can allow you to compare different loans and ensure you're choosing the right option for your financial needs and goals.

• You can pay off your debt faster: Small, extra payments each month towards your principal balance can save you money when it comes to interest. Even $20 or $30 extra helps!