The Beginner's Guide to Amortization

Amortization is the paying off of a loan over time. This is a general term that, despite the name, doesn't necessarily relate to mortgages and homeowner's loans. The process of amortization, or "paying off", is determined by the loan amount, the time period in which you have to pay back, and the interest rate.

Here is an example of amortization:
If you purchase a home for $150,000, and you pay a $20,000 down payment, you're left with a home loan or mortgage of $130,000. You will re-pay this to your lender over a mutually determined period of time.

Suppose you and your lender agreed on a period of 30 years, with an annual interest rate of 6%. What would be your monthly payment?

You would take the principle loan amount of $130,000 and divide by the number of months in 30 years. With 12 months in a year, that would come to 360 months. You have to factor in the interest rate of 6% by calculating the compound interest over those 30 years. This would make your monthly payment around $780.00.

This sounds fairly straight forward, but in reality, it's not. Monthly payments will be used to pay off the interest first, with a small portion going toward repaying your loan. Taking the previous example's monthly payment of $780.00 – about $650 will be used to repay interest while the left over $130 will go toward the principle loan amount. For each subsequent monthly payment, the amount of interest paid is reduced. As you approach the 30-year mark, your interest paid would be the minimum, while the majority of your monthly payment would go toward repaying the principal.

Most people don't have the time to sit down and calculate the amount going toward paying off the principal each month. There are many free amortization calculators on the Internet that can help you calculate these numbers. Calculating your monthly payment will help you decide which loan to take, and your lender can also provide further guidance with this process.

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