Loan Amortization Explained Simply
Understand how your loan payments are split between principal and interest over time, and learn how extra payments can save you thousands of dollars.
What is Loan Amortization?
Loan amortization is the process of paying off a debt over time through regular payments. Each payment covers both interest charges and a portion of the principal balance. The way these payments are structured determines how quickly you pay off the loan and how much total interest you'll pay.
- Principal: The original loan amount you borrowed
- Interest: The cost of borrowing, charged as a percentage
- Term: The total time you have to repay the loan
- Amortization Schedule: A table showing how each payment is split between principal and interest
How Loan Payments Break Down
Early in your loan term, most of your payment goes toward interest. As time passes, more goes toward reducing the principal. This happens because interest is calculated on the remaining balance, which decreases with each payment.
First Payment (Month 1):
- Total payment: $1,520
- Interest: $1,125 (74%)
- Principal: $395 (26%)
- Remaining balance: $299,605
Payment at Year 15 (Month 180):
- Total payment: $1,520
- Interest: $759 (50%)
- Principal: $761 (50%)
- Remaining balance: $202,228
Final Payment (Month 360):
- Total payment: $1,520
- Interest: $6 (0.4%)
- Principal: $1,514 (99.6%)
- Remaining balance: $0
The Power of Extra Payments
Making extra payments toward your principal can dramatically reduce the total interest paid and shorten your loan term. Even small additional payments make a significant difference over time.
Standard Payment ($1,520/month):
- Loan term: 30 years (360 months)
- Total paid: $547,200
- Total interest: $247,200
With Extra $200/month ($1,720/month):
- Loan term: 22.5 years (270 months)
- Total paid: $464,400
- Total interest: $164,400
Savings: $82,800 in interest + pay off 7.5 years earlier!
Different Types of Amortization
Regular equal payments over the loan term result in zero balance at the end. Examples: most mortgages, auto loans, personal loans.
Regular payments don't fully pay off the loan by the end of the term, leaving a balloon payment due. Common in some commercial real estate loans.
Payments are less than the interest charged, causing the balance to grow. Rare and generally not recommended. Can occur with certain adjustable-rate mortgages.
Reading an Amortization Schedule
An amortization schedule shows exactly how each payment is allocated. Understanding this schedule helps you see the impact of extra payments and plan your payoff strategy.
| Month | Payment | Principal | Interest | Balance |
|---|---|---|---|---|
| 1 | $1,074 | $241 | $833 | $199,759 |
| 2 | $1,074 | $242 | $832 | $199,517 |
| 3 | $1,074 | $243 | $831 | $199,274 |
| 4 | $1,074 | $244 | $830 | $199,030 |
| 5 | $1,074 | $245 | $829 | $198,785 |
| 6 | $1,074 | $246 | $828 | $198,539 |
Strategies to Pay Off Loans Faster
- Make biweekly payments:Pay half your monthly amount every two weeks (equals 13 monthly payments per year)
- Round up payments:Round your payment to the nearest $50 or $100
- Apply windfalls to principal:Use tax refunds, bonuses, or raises for extra principal payments
- Refinance to shorter term:Switch from 30-year to 15-year mortgage when rates are favorable
- Recast your mortgage:Make large principal payment and have lender recalculate your monthly payment
Key Takeaways
- •Early loan payments are mostly interest; later payments are mostly principal
- •Extra principal payments reduce total interest and shorten loan term dramatically
- •Even small additional payments compound to significant savings over time
- •Review your amortization schedule to understand where your money goes
- •Making extra payments early in the loan term has the greatest impact