Investing

The Amortization Formula, And How Amortization Works

When you take out a bank loan, you agree to an interest rate, a monthly payment amount, and the length of time that your loan will continue. In the documents the bank gives you, you’ll find an amortization table showing each payment you’ve committed to make until the loan is paid off. You’ll also see the total amount of interest you’ll pay over the life of the loan. The bank uses the amortization formula to calculate these numbers.

Amortization allows the loan to be paid down by combining the principle and the interest into a single monthly payment. While the payment remains the same each month, the amounts going toward interest and principle vary from month to month.

What is the amortization formula?

The formula looks complicated, and it is! But fear not, there are many online calculators that can do the math for you. 

The amortization formula is complex, however there are several calculators available online.

As long as you have the four pieces of information listed above, you can use an online calculator to determine the amount due each month. The calculators use the amortization formula to calculate the payment, and many even offer an amortization table to show you how your payments will be distributed over time.

How can I determine the number of payments for my loan?

Most loans are repaid monthly, so the number of payments would be 12 multiplied by the number of years of the loan. For example, a typical mortgage loan is 30 years, so the number of payments would be 360 (30 years times 12 months per year). 

How do I determine the interest rate per period?

To find this number, take the annual interest rate and divide it by the number of payments each year. For example, if your interest rate is 6%, your interest rate per period is .5% or 0.005.  

Why am I paying down so little principle?

Look over the amortization table provided by the bank. You might be surprised to see that at the beginning of your loan, the majority of your payments are merely going to pay off the interest your loan has accrued. This can be disheartening, but check out that final payment – you’ll be paying almost no interest, and the majority of your payment will go to the loan principle.

When you make a payment, the payment will be applied first to the interest your loan has accrued and the remainder will go toward the principle. Let’s look at an example of a 30-year mortgage of $100,000 at 5% interest. In this example, your first payment of $536.82 will pay off $416.67 in interest and only $120.15 toward the loan principle. However, the last payment you make will pay a whopping $534.59 toward the principle and a meager $2.23 toward interest.

How can I lower the cost of my loan?

If you’re choking at the thought of paying so much interest over the life of your loan, there may be some things you can do to save yourself money over time.

Borrow less money

The best way to save money on interest is to simply borrow less. Saving up for a bigger down payment can lower your monthly payment and help you borrow less money. You might even be able to shorten the term of your mortgage from thirty years to twenty or fifteen years.

Lower your interest rate

If you already have a mortgage, keep an eye on interest rates. Refinancing when interest rates are low could save you a lot of money over time.

Make extra payments

You could also consider making extra payments towards your mortgage if you have some wiggle room in your budget. Paying off additional principle each month means that you’re borrowing less money over time. You’ll pay less in interest each month and end up paying off your home earlier than planned. 

Even if you can only afford a small amount extra each month, these payments add up quickly. Paying an additional $50 per month on the $100,000 mortgage in our example above results in saving $18,534.81 over the life of the loan and paying it off five years early!

The amortization formula is complicated, but you don’t need to be able to do the math to understand how it works. Once you learn how interest and principle are applied to your loan, you can use that information to make wise choices about your financial future.