Loan Amortization: How Payments Work

Amortization is the process of spreading loan payments over time in equal installments. Each payment covers both interest (the cost of borrowing) and principal (the actual debt). The key insight: While your payment stays the same, the proportion going to interest vs. principal changes dramatically over the loan term. In the early years: • Most of your payment goes to interest • Very little reduces your principal balance In the later years: • Most of your payment reduces principal • Less goes to interest This happens because interest is calculated on your remaining balance. When you owe $300,000, you're charged interest on $300,000. When you owe $50,000, you're only charged interest on $50,000.

An amortization schedule shows exactly how each payment breaks down over the life of your loan. Example: $300,000 mortgage at 5% for 25 years • Monthly payment: $1,754 • Total payments over 25 years: $526,200 • Total interest paid: $226,200 First payment breakdown: • Interest: $1,250 (71%) • Principal: $504 (29%) • Remaining balance: $299,496 Payment at year 15: • Interest: $722 (41%) • Principal: $1,032 (59%) • Remaining balance: $170,628 Final payment: • Interest: $7 (0.4%) • Principal: $1,747 (99.6%) • Remaining balance: $0 Notice how dramatically the allocation shifts. In your first payment, over 70% goes to interest. By the end, almost nothing does.

The front-loaded interest structure has major implications: 1. Refinancing resets the clock If you refinance after 10 years, you start a new amortization schedule. You go back to paying mostly interest, losing the benefit of years of principal payments. 2. Early payoff saves exponentially more Extra payments in year 1 save far more interest than extra payments in year 20 because that principal would have accumulated interest for decades. 3. Shorter terms save significantly A 15-year mortgage has higher payments but dramatically less total interest than a 30-year mortgage. Comparison: $300,000 at 5% • 25-year term: $1,754/month, $226,200 total interest • 20-year term: $1,980/month, $175,200 total interest • 15-year term: $2,372/month, $126,960 total interest The 15-year mortgage saves nearly $100,000 in interest!

1. Make extra principal payments Even small extra amounts early in your loan can save thousands. $100 extra monthly on our example loan saves approximately $30,000 in interest and pays it off 4 years early. 2. Switch to biweekly payments Paying half your monthly payment every two weeks results in 26 half-payments (13 full payments) per year instead of 12. This one extra payment per year can shave years off your mortgage. 3. Round up your payments If your payment is $1,754, pay $1,800 or $2,000. The extra goes straight to principal. 4. Apply windfalls to principal Tax refunds, bonuses, and inheritances can make a significant impact when applied to your loan balance. 5. Refinance to a shorter term If rates have dropped or your income has increased, refinancing to a 15-year loan (if you can afford it) saves dramatically on interest. 6. Make one extra payment per year Just one additional payment annually can reduce a 25-year mortgage by 4-5 years.

Standard amortization Equal payments throughout the loan term, with shifting interest/principal proportions. Most common for mortgages and auto loans. Negative amortization Payments don't cover interest, so the balance grows. Dangerous and rare today, but seen in some adjustable-rate mortgages. Interest-only loans You pay only interest for a period, then face higher payments later. Your balance doesn't decrease during the interest-only period. Balloon loans Smaller payments with a large lump sum due at the end. Risky if you can't refinance or pay the balloon. Graduated payment plans Payments start low and increase over time. Can help early-career borrowers but costs more in total interest. Simple interest loans Interest calculated on current balance daily rather than monthly. Paying early each month saves more. Common for auto loans.

Every amortization schedule includes: Payment number: Which payment in the sequence Payment amount: Your fixed monthly payment Interest portion: How much goes to interest Principal portion: How much reduces your balance Remaining balance: What you still owe Key things to look for: 1. The crossover point When principal exceeds interest in your payment. For a 25-year mortgage, this typically happens around year 12-15. 2. Total interest The sum of all interest payments. This shows the true cost of borrowing. 3. Impact of extra payments Many calculators let you model extra payments to see how they affect your payoff date and total interest. 4. Early payoff scenarios See how increasing your payment by various amounts changes your loan term and total cost.