A Guide to How Amortization Works

Are you thinking of taking out a loan to buy a new home as property values keep rising? Or maybe you’re eyeing a more reliable car while stuck in traffic, wondering how you’re still driving that 10-year-old clunker? Perhaps you’ve had a big change in your family, like the arrival of new children or an elderly parent moving in, making you consider a loan to expand your living space.

No matter what you’re borrowing for, there’s a crucial concept to understand: Amortization. It’s a part of every loan, whether it’s from a bank, credit union, or a car dealership’s financing. So, what exactly is amortization?

What is Amortization?

In simple terms, amortization is the process of paying off a loan through regular payments over time, typically monthly. Each payment reduces both the loan balance (principal) and the interest owed.

The best way to understand amortization is by using an amortization calculator, which you can find for free online. These calculators ask for a few key details:

• The loan term (length of the loan)
• The interest rate
• The total loan amount
• The loan start date

Example: Buying a Home

Let’s imagine you’re looking to buy a new home and want to borrow $300,000. This is a common scenario since the average home price in the U.S. is around $335,000.

If you enter $300,000 for the loan amount, choose a 30-year mortgage, and get an interest rate of 6.37% (the current average), with a start date of September 24, 2024, what would the amortization calculator reveal?

First, it will give you a summary of the loan terms. Based on these details, your monthly payment would be $1,871.

Next, the total cost of the loan comes into play. Brace yourself—after making all your payments over 30 years, the total amount you’d repay is $673,426!

You might be thinking, “I only borrowed $300,000! How did it grow to $673,426?” The answer lies in interest. Over the life of the loan, you’d pay $373,426 in interest. So, your lender is making a significant profit from your loan.

The calculator will also tell you when your loan will be fully paid off. In this case, your final payment would be due in September 2054, exactly 30 years after the loan began.

Breaking Down Your Payments

Here’s where amortization gets interesting. When you make your first payment of $1,871 in October, only $278.13 goes toward the loan’s principal, while $1,592.50 covers the interest.

As time goes on, the balance shifts. After a year of making payments, you’ll still be paying mostly interest, with only about $296 going toward the principal each month. By that point, you’ll have made over $22,000 in payments but will only own about 6.34% of your home.

By the fifth year, after more than $112,000 in payments, you’ll own around 30.81% of the house. At the 10-year mark, you’ll own 59.32%, and by the 20th year, you’ll still be paying $1,871 each month. However, $991 of that will go to the principal, and $879 to interest. At this point, your remaining loan balance would be about $164,716.12.

Reducing Interest Costs

While amortization shows how much interest adds up, there are ways to reduce these costs:

• Opt for a shorter loan term: For example, choosing a 15-year loan instead of a 30-year loan could save you over $260,000 in total. Your monthly payments would increase to $2,592, but if you can manage the higher payments, the savings are substantial.
• Apply this to car loans too: Many people choose 6-year car loans, but if you can pay off your car in 4 years instead, you’ll save a significant amount on interest.
• Make additional payments: If your loan terms allow, making extra payments toward your principal will help you pay off the loan faster and reduce the overall interest you pay.
• Negotiate a lower interest rate: Even a small reduction in your interest rate can lead to big savings over the life of the loan.

Conclusion

Loans are a major part of life for many people. But it’s essential not to go into them blindly. Understanding how loans work through amortization will help you make more informed decisions and potentially save you a significant amount of money in the long run.