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Loan Amortization

What is Loan Amortization?

Mortgage amortization plays on two segments of each monthly payment: one part is reserved for the principal and the other part is reserved for the interest charged over a period of time until the principal is completely paid off at the scheduled end of the loan term. In short, an amortizing loan is one where the principal balance is being reduced over the course of the loan's life as a result of the scheduled (monthly) payments made towards it.

Below is an example of a loan on a house. The first table describes the amount of the principal balance the borrower has acquired from their lender. Over the course of 30 years, each month of every year needs to account for $1,297.20 to pay off the loan on time or the borrower will risk incurring additional late fees.

Loan Data
 Original Principal  $200,000
 Loan Term (Years)  30
 Annual Interest Rate  6.75%
 Payments per Year  12
 Payment  $1,297.20


The Amortization in Action table illustrates how your payments are being split between the interest charged and the principal owed on the house.

With every successive month, the interest charged is drawing closer and closer to $0. The principal will be approaching the closing amount ($200,000). The monthly payments themselves do not change, it's only the percentage of the cash that reallocates itself towards less interest, and more towards the principal. The money you pay each month on your mortgage is, therefore, being divided into two surplus quantities that cover the principal owed, along with the interest on that principal. Eventually, the monthly payments will cover the original loan and the security charge for acquiring that loan.

Amortization in Action
Month Payment Interest Principal Balance
0       $200,000
1 $1,297.20 $1,125.00 $172.20 $199,827.80
2 $1,297.20 $1,124.03 $173.16 $199,654.64
3 $1,297.20 $1,123.06 $174.14 $199,480.50
4 $1,297.20 $1,122.08 $175.12 $199,305.38
5 $1,297.20 $1,121.09 $176.10 $199,129.28
6 $1,297.2 $1,120.10 $177.09 $198,952.18


It holds true that the proper process of amortization itself is made up of the inverse relationship between the interest due and the principal owed. However, whenever a monthly interest cost is not paid in full, additional charges are incurred that increase the outstanding balance of the mortgage, resulting in the borrower owing more money. This is called negative amortization.

Always Read the Fine Print

In terms of your mortgage, don't rush into any personal method of payment that wasn't brought to your lender's attention. The lender's binding contractual agreement states that your payments have to be in certain timely intervals and of a certain amount. Changing and altering this routine could be met with penalizing charges. Always make sure that what you're doing is well within the legal parameters.

Assuming you're clear on your lender's guidelines, here's a brief explanation of where the extra money goes:

  • In a fixed-rate mortgage, paying more to reduce the principal owed can either shorten the time period in which you're supposed to cover the loan or reduce the monthly interest costs imposed on the loan.

  • In an adjustable-rate mortgage, paying more does not guarantee that the loan term will be reduced because of variable interest rates. That extra amount would simply go towards covering your principal loan and reducing that year's current annual percentage rate.

  • Doubling one month's installment does not make next month's payment unnecessary. This goes back to the contractual agreements which typically state that payments need to be made at timely intervals. If the contract permits it, the extra money could go towards decreasing the principal owed or the life of the loan. 

Any late payments will be met with cumulative charges until they are covered or you (the borrower) will suffer a default.

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