What is loan amortization and how does it work?

Loan amortization sounds like a complicated term, but its meaning is fairly straightforward. Amortization refers to the series of regular payments you make on a loan in order to pay off both interest charges and the principal balance over time. 

Your lender might share your amortization schedule so that you can see exactly how each monthly payment you make is applied to the outstanding balance you owe. You can also use online amortization calculators to see your repayment schedule or you can even calculate it by hand. 

If you’re wondering how loan amortization works, here’s what you should know.

What is an amortized loan?

An amortized loan is a type of loan that’s paid off over a certain period of time, usually with fixed monthly payments. After collecting each payment, your loan servicer will apply some of it to the interest charges on your loan and the rest to the loan’s principal balance. At the end of your repayment term, you’ll have paid off your loan and interest charges in full. 

Amortized loans can be unsecured or secured, with some common types including: 

• Personal loans.
• Fixed-rate mortgages.
• Home equity loans. 
• Auto loans.
• Student loans.

Keep in mind: Revolving credit lines — such as credit cards and home equity lines of credit (HELOCs) — aren’t considered amortized loans. This is because these kinds of credit let you borrow on an ongoing basis and pay back your debt as you go.

How loan amortization works

Loan amortization outlines how your loan servicer applies your monthly payments to your debt over time. While you’ll pay the same amount each month, how much of your payment is allocated to your principal balance and to interest will change over the life of the loan. 

At the beginning of an amortization schedule, a greater amount of your payment goes toward interest charges than to paying down your principal balance. Over time, however, that ratio will flip, and more of your payments will go toward your principal until you’ve paid off your loan in full. 

For loans with shorter repayment timelines, the amortization period is shorter, which means you’ll pay less interest overall. Conversely, longer amortization timelines will cost you more in interest. In general, it’s best to choose the shortest repayment term (and therefore shortest amortization schedule) that you can afford to keep your interest costs as low as possible. 

Tip: Many lenders also let you make extra payments if you want to get out of debt faster.

“If you can afford an extra payment on your loan, it is smart to request the lender to apply all the additional dollars to pay off the principal balance, which will accelerate the loan payoff, shorten the payoff term of the loan and reduce the total interest paid on it,” says Ohan Kayikchyan, certified financial planner (CFP) and founder of The Money Doctor.  

How to calculate amortization

The easiest way to calculate amortization is with an online loan amortization calculator. Most of these calculators ask you to enter your loan amount, interest rate and repayment term and then instantly provide your amortization schedule. 

If you’d like to calculate loan amortization by hand, you can also use the following formula: 

P {[r (1+r)^n] / [(1+r)^n – 1]} = Monthly payment

• P = Principal loan amount.
• R = Monthly interest rate (calculate this by dividing your annual rate by 12 or however many payments you make each year).
• N = Total number of payments you’ll make on your loan.

Example of loan amortization

Say you take out a $10,000 loan with a 6% interest rate that’s amortized over three years. Here’s how you’d calculate the monthly payment using the above formula:

$10,000 {[0.005(1+0.005)^36] / [(1+0.005)^36 – 1]} = $304.22 

After you’ve determined the monthly payment, you can also figure out how much of it will go toward interest by multiplying your principal loan amount by your interest rate. In this case, $10,000 x 0.06 = $600. 

Dividing that number by 12 months, you’ll pay $50 toward interest your first month. With your monthly payment of $304.22, that means $50 will go toward interest and the remaining $254.22 will pay down your principal balance. 

To calculate your loan amortization for subsequent months, you’ll use the same formulas — however, you’ll input your new outstanding principal balance rather than the original principal. In the second month, for example, your outstanding balance would be $9,745.78 after subtracting the $254.22 that went toward your principal in the first month. 

What is a loan amortization schedule?

A loan amortization schedule is typically a table showing how your payments are applied to your balance each month. If you’re paying off a loan over 120 months, for example, the amortization schedule will contain 120 rows that include the following information: 

• How much of your payment goes toward the principal balance each month (this amount will increase over time).
• How much of your payment goes toward interest charges each month (this amount will decrease over time). 
• Your outstanding balance after each payment.

Your amortization schedule might also contain the following information about your loan: 

• Your loan amount, repayment term and interest rate. 
• Amount of your payments, which you’ll typically make monthly. 
• Total number of loan payments you’ll make on your loan. 

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Why loan amortization matters

Loan amortization helps you understand how repayment works on your loan over time. In any given month, you can consult your amortization schedule to see how much of your payment is being applied to your principal balance and how much is going to interest. You’ll also see your outstanding balance and how much more you have to pay to close out the debt in full.  

Ultimately, understanding the repayment terms and schedule of your loan can help you manage your finances better and come up with a plan for debt repayment that works for you and your financial goals. 

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