Amortization Made Simple

The gradual repayment of a loan by installment payments, calculated to pay off the obligation by a specified period of time. Each installment payment consists of a payment which is applied towards both principal and interest.

Amortization: Why should you care?

The amortization of a loan reveals the true amount needed to repay the loan.

• During the early years of the mortgage term, a big part of the mortgage payment is applied towards paying interest. Over time, the amortization schedule calls for applying a larger part of the payment toward repaying principal — the amount borrowed.
  • Since you pay more interest during the early years, income tax benefits are generally greater in the early years, but decline over time.
    
  • In contrast, due to the amortization process your monthly payments will build less equity during early years compared to the end of the loan’s term.
• The longer the loan’s amortization period — 5, 15, 30, 40 years — the more overall interest expenses you will pay. A loan with a 15-year amortization period will cost you less in overall interest expense paid than a 30-year amortization period.
• Negative amortization is a feature of some loans, where because the monthly payment is not large enough to cover the accrued interest due, the amount of the shortfall is added to the remaining balance which thereby increases and creates “negative” amortization. You are not amortizing or repaying your loan at all—the balance is getting bigger!
  • Long amortization schedules can also make sense when a borrower is just getting started—buying a homes and raising a family while still in the early earning years.
  • Shorter amortization schedules make more sense when buying items that quickly fall in value.

Amortization: Which way to go?

As a general rule, longer amortization terms may make sense when the loan is to buy something that maintains or grows in value.

Beware of high interest department store credit cards. Avoid purchasing “sale” items on credit if it’s going to take you too long to pay off the balance. Don’t splurge on a department store “sale”…then take 18 months paying for it on credit. The “savings” are more than wiped out by the high interest expense.