What is Amortization?

Amortization is the process of establishing equal periodic payments such that the payments will pay off the entire principal and interest by the end of the loan term. For example, the monthly payment on a 30 year mortgage loan will pay off the entire loan amount and interest over the 30 year period.

The amortization period is the time period during which the entire principal amount will be paid off. An amortization schedule shows the calculation of periodic interest and the application of monthly payment towards the principal and interest. Amortization table is also known as an amortization schedule.

Amortization creates equal monthly payments, sometimes known as equal monthly installments (EMI). With the equal payments, the borrower can plan the cash flows and build a budget.

Properties of Amortization

Amortization and Application of Payments

During the earlier part of the loan term, majority of the periodic payment is applied towards interest. As we get towards the latter half of the amortization schedule, the payments are increasingly applied towards principal. The chart below shows how the monthly payment is applied between interest and principal for a 30 year loan at 6%.

The proportion of payment that is applied towards interest versus principal payment is determined by interest rate and loan term. Irrespective of the loan amount, the distribution between interest rate and principal payment for any given period stays the same as long the interest rate and loan term stays the same.

Amortization and Interest Rate

As interest rate increases the percentage of payment applied towards principal in the initial years gets smaller. In other words, as interest rate increases the total interest expense becomes higher and the borrower experiences smaller principal pay-down in the initial years. The chart below shows how distribution of monthly payment between interest and principal changes as we increase interest rate.

Amortization and Loan Term

The amount of monthly payment reduces as the loan term increases. The reduction in monthly payment is because the principal portion of the payments gets spread over the longer loan term.

For example, the monthly payment for a 15 year mortgage of $100,000 at 6% is $843.86. The payment for 30 year mortgage and 40 year mortgage is $599.55 and $550.21 respectively. In these cases, the same principal amount of $100,000 is being repaid over 15, 30, or 40 year loan term. In fact, as we increase the loan term, the initial monthly payment amount approaches interest only payment. An implication of this relationship is that with increase in loan term the build up of equity in the initial years gets reduced.

Updated: Jan 09, 2017