In finance industry Amortization is referred in two ways. Both refers towards the regular payments for a period of time. In English, generally mortem means “to kill”. it wont be wrong if we say that amortization refers to killing off the loan.
Amortization refers to the repayment of secured loans with a fixed repayment schedule in regular installments over the period of time.
The repayment model includes both the interest and the principal amount. In the beginning of a home loan or an auto loan, major part of the monthly payments includes the interest amount whereas in the later stage with regular payments, the payment includes the greater percentage of principal amount. The complete loan amount is divided into equal payments until it is paid off. Every time the payment is made, the principal amount varies and the remainder goes to the interest.
There are various methods to develop the amortization schedule :
- Straight line (Linear – repayment with fixed number of fixed amount monthly installments)
- Declining Balance (Reducing Balance)
- Annuity (payments made at regular intervals)
- Bullet (payment at once)
- Balloon (amortization payment or large end payment)
- Increasing Balance (negative amortization)
The schedule works is chronological order. The last payment of the loan will be different from its earlier payments. In addition to break down the amortization schedule into interest and principal proportions, it indicates the interest paid till date, principal paid till date and the remaining balance principal on each payment date.
The schedule of amortization is based on the following assumptions:
Firstly, the borrower has to understand that rounding errors occur. It depends on the lender how they rectify or accumulate the mixed amount (principal & interest). this amount on monthly basis may vary for few month. The accumulated errors are adjusted either at the end of the year of at the end of the loan term.
Few important points are to be noted before borrowing a loan. There has to be large and different allocation of the monthly payment towards the interest, especially in the early years (may be 3.5 years) of the 7 year car loan.
For a fully amortized loan, with a fixed rate of interest, the payment remains the same through out the life of the loan despite of the principal balance owed. Paying off more than the fixed amount reduces the outstanding amount and also the interest amount. If the fixed monthly amount remains the same then the number of payments and the loan term must decrease. On the other hand, paying lesser amount than the fixed amount increases the outstanding as well as the interest amount. If the monthly payments remain the same, the number of payments and the loan term must increase.
Amortization table indicates the process of paying off the loan with details for every payment made. It provide the details of the loan balance, interest charges on the loan and the principal amount. It helps to understand and predict the loan amount or interest cost at any given point of time. It also helps to understand if borrowing a loan is really needed, loan can be paid off early or which loan in less expensive. The tags of the table includes :
Monthly payment: the table shows the every payment made towards the loan repayment.
Interest Expenses: Interest is charged on the loan amount every month. To calculate the interest the rate of interest is multiplied with balanced loan amount.
Principal repayment: after paying the interest charges the balance amount goes towards the principal. The balance amount decreases over the time if you move through an amortization schedule.
Cumulative interest : few amortization table sum up the interest and the payments over the time. It shows how much you are paying towards interest with each payment. With this column it is easy to find the interest paid over the first (or last) three years of the loan.
Extra payments : though there is no option for extra payments. One can easily calculate the benefits associated with early pay offs.
Fees (besides interest) : amortization schedule generally do not show any additional fees that one has to pay towards the loan.. one has to evaluate the orientation or early closure charges separately.
The amortization table works best with the loans that have the following characteristics:
- They are all at once loans
- They have fixed rate of interest
- They have fixed installments
- They get paid down over the time
Loan type can be a fixed rate mortgage, auto loan, personal loan, home equity loan and similar loans. The other loans especially with variable rate of interest are difficult to be calculated. Amortization is difficult with adjustable rate mortgages as the interest rate might change at any point of time in future.
Sample of Amortization Table