Amortization is the process of paying off a debt over time through regular payments. Each payment is divided between interest charges and reducing the principal balance. In the early years of a loan, a larger portion of each payment goes toward interest, but over time, more of each payment goes toward the principal.
This concept is most commonly associated with mortgages and auto loans. When you take out a 30-year mortgage, for example, your monthly payment stays the same throughout the loan term, but the breakdown between principal and interest changes dramatically.
Understanding amortization is crucial because it affects how quickly you build equity in your home and how much total interest you'll pay over the life of the loan. Making extra principal payments can significantly reduce your total interest costs and shorten your loan term.
In accounting, amortization also refers to spreading the cost of an intangible asset (like patents or trademarks) over its useful life. However, for most consumers, amortization primarily relates to loans.
Key Variables
- M: Monthly payment
- P: Principal (loan amount)
- r: Monthly interest rate (annual rate ÷ 12)
- n: Total number of payments
Mortgage Amortization Example
For a $300,000 mortgage at 6% interest over 30 years:
- Monthly payment: $1,799
- First payment: $1,500 goes to interest, only $299 to principal
- After 15 years: $833 goes to interest, $966 to principal
- Final payment: Almost entirely principal
- Total interest paid over 30 years: ~$347,515
Key Takeaways
- Early payments are mostly interest, late payments are mostly principal
- Extra payments toward principal can save thousands in interest
- Shorter loan terms mean higher payments but less total interest
- Amortization schedules show exactly where each payment goes