What is amortization? (2023)

How does an amortization schedule work?

An amortization schedule is a table that outlines the repayment of a loan over time. It breaks down each periodic payment into two components: the principal and the interest.

“In the early stages of your mortgage term, a larger proportion of your monthly payment is allocated toward interest, while a smaller fraction contributes to reducing the principal,” said Shekhtman. “As you consistently make payments over the years, the balance shifts, and more of each payment is directed toward reducing the principal.”

In this example, you can see the amortization schedule for a mortgage of $400,000 with a fixed interest rate of 5% and a 30-year term. This is what the buyer would expect to pay in the first five years — notice more money goes toward the interest:

In the first year, your total interest paid would be $19,865.98. By the fifth year, you would have paid $96,152.12 in total interest.

Here’s what the last five years of the amortization schedule would look like:

When you make the final payment at the end of 30 years, your loan will be completely paid off. The total interest paid by the end of the loan will be $373,023.14. This is in addition to the $400,000 paid toward the principal.

Calculating amortization

The general formula for calculating how much of your monthly payment goes toward principal and how much goes toward interest is:

Let’s go back to the example of the $400,000 loan at 5.00% interest for 30 years and calculate the components of the third monthly payment. First, calculate the interest due for the month by multiplying the monthly interest rate (0.05 divided by 12) by the remaining loan balance. In our example, the monthly interest rate is 0.416667%.

Interest due for the period = remaining loan balance x (annual interest rate divided by 12)

If two months have passed, the remaining loan balance is $399,036.76. When you multiply this figure by the monthly interest rate, you get $1,662.65. This is how much interest will be due for your third monthly payment.

To calculate how much principal is paid down in each payment, you subtract the interest from the fixed monthly payment. That’s $2,147.29 minus $1,662.65, which equals $484.64. The principal will be reduced by $484.64 with the third monthly payment.

Amortization vs. depreciation

Amortization is similar to depreciation in that both concepts reflect a gradual reduction in the value of specific items. But the two terms have slightly different meanings. Amortization refers to how the value of an intangible item, like a mortgage, decreases over time.

Depreciation, on the other hand, refers to how a tangible asset, like a car, loses its value over time. If you bought a car a few years ago, it’s likely not worth as much now as it was when you first purchased it. Similarly, you might have heard of businesses depreciating their assets and assigning expenses to these devaluations each year.

» MORE: How much house can I afford?

Benefits of amortization

“For buyers, comprehending amortization helps in grasping how their monthly payments are distributed and how their equity in the property grows with time,” said Shekhtman. “It also presents an opportunity for loan acceleration and reduction of overall interest paid through making extra payments.”

As Shekhtman mentioned, mortgage amortization allows a borrower to build home equity with each monthly payment they make. As the principal is paid down, the homeowner increases their equity, or ownership, in the property. Equity can be useful if the homeowner chooses to sell or refinance the property.

Disadvantages of amortization

With amortization, you aren’t paying off much of the principal in the beginning. Interest is calculated from the remaining balance, so your interest costs are pretty high until you start to make a dent in the principal. The longer the loan term, the greater your interest costs will be.

Additionally, some mortgage types, such as balloon mortgages, are not fully amortized and may have low monthly payment amounts until a large lump-sum payment is due. This means facing a significant payment at the end of the loan term and a potential foreclosure if you haven’t saved up enough money to cover that huge payment.

» MORE: How does a mortgage work?

Bottom line

An amortization schedule provides a roadmap for a borrower, letting them know how much of their monthly payment will go toward principal and interest. Understanding how significant a role amortization plays in your loan can help you decide between a fully amortized mortgage with stable payments and an alternative mortgage type, like a balloon mortgage. It can also motivate you to pay off your mortgage early.