What is amortization?
Wait, don't run away ...
You can define the term easily if you have a solid education in the basics of
finance. You probably know what it is if you've bought a house once or twice.
Or maybe you know sorta, kinda what "amortization" means, but not really.
You wouldn't bet the farm that you completely understand the word.
For an explanation,
let's turn to experts who promise not to bore you to tears.
up, we have Philip Russel, assistant professor of finance at Philadelphia University,
who defines amortization as "the systemic payment plan -- such as a monthly
payment -- so that your loan is paid off over the specified loan period."
So an amortized loan is for one specific amount that is to be paid off by a certain
date, usually in equal monthly installments. Your car loan and home loan fit that
definition. Your credit card account doesn't because it's a revolving loan with
no fixed payoff date.
That's only part of what lenders mean
when they talk about amortization.
Chris Edwards, manager
of the business-to-consumer Web site for IndyMac Bank Home Lending, a mortgage
lender, points out that "amortization" arises from a Latin term that
means "to deaden," and that a common dictionary definition includes
the phrase "gradual extinguishment."
term sounds about as fun as a 'pre-need' funeral service sales presentation,"
(By the way, the word "mortgage"
has the same Latin root, and literally means "dead pledge." The property
is "dead" to the borrower if he defaults on the debt, and the pledge
is "dead" to the lender after the loan is repaid. That's how people
coined words in the 14th century.)
Amortization is less about
death than about shrinkage (or "gradual extinguishment").
part of the payment goes toward the interest cost and the remainder of the payment
goes toward the principal amount -- the amount borrowed," Russel says. Interest
is computed on the current amount owed "and thus will become progressively
smaller as the ending balance of the loan reduces." See? Shrinkage.
Back to Edwards: "If you've ever had a mortgage, you'll know that you seem
to pay a lot toward interest and not much toward the principal balance for the
first several years of your loan," he says. "This isn't a complex financial
scheme dreamed up by gray-suited bankers in an underground conference room, but
rather simple mathematics."
Take a mortgage loan for
$100,000 at 6.5 percent for 30 years. The monthly principal and interest payment
is $632.07. For the first month, you owe interest for $100,000, which equals $541.67.
The remainder of the payment, $90.40, goes toward principal. In other words, your
debt is reduced by $90.40.
"Next month, you only
owe interest on $99,909.60, so $541.18 goes to interest and $90.89 goes to principal,"
Edwards says. "Month after month, your interest portion will decrease a bit
and your principal reduction will increase. This process continues until your
360th payment contributes $3.41 to interest and $628.66 to principal."
You can see how this works by consulting Bankrate.com's mortgage
calculator, which lets you type in any mortgage amount, interest rate and
term, or length of loan.
The calculator gives you the option
of looking at an amortization table, also known as an amortization schedule. This
table tells how much interest and how much principal is included in each monthly
payment, from the first to the last.
In the above example, "you'll be delighted
to see that after 256 payments, you've paid off about half of your loan,"
Edwards says. That's 21 years and four months. You pay off the other half of the
principal in the remaining eight years and eight months.
if the loan above amortized for 15 years instead of 30 years, the monthly principal
and interest would cost $871.11.
In the first month, you still
would pay $541.67 in interest because the amount of the loan is the same and the
interest rate is the same. But you would pay $329.44 in principal with that first
payment because you're paying off the loan quicker.
so it's not simple mathematics, but it's not exactly deadening either," Edwards