Amortization
Definition
The gradual repayment of a loan through scheduled payments of principal and interest.
How It Works
Each payment covers interest on the remaining balance plus a portion of principal. Early payments are mostly interest; later payments are mostly principal.
Example
A $200,000 mortgage at 5% for 30 years has monthly payments of $1,073.64.
Common Misconceptions
- ✗All of each payment goes to principal
- ✗Amortization only applies to mortgages (it applies to any installment loan)
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Common questions about Amortization
Calculate interest on the remaining balance, subtract from the payment to get the principal portion, reduce the balance, and repeat.
Because the outstanding balance shrinks with each payment. Interest is calculated on the remaining balance, so as principal is paid down, less of each subsequent payment goes to interest and more goes to reducing the loan balance.