What Is Amortization? A Guide to Loan Repayment

When you take out a loan, it can be discouraging to see that your initial payments barely seem to make a dent in the overall balance. This happens due to amortization, and it affects nearly every mortgage, auto loan, and personal loan.

Amortization determines how much you pay in interest each month and how quickly you build equity or pay down debt. Understanding how amortization works can help you make better financial decisions.

What is amortization?

Amortization refers to the process of paying off your loan through regular payments over time. A percentage of your monthly payment is applied to the principal (the original amount you borrowed) and interest, with a schedule showing how much money goes toward each.

“Amortization schedules are most often seen as part of a fixed-rate mortgage, auto loan, and many personal loans, where the repayment process is structured to pay off an entire loan amount over time,” explains Andreis Bergeron, a mortgage loan originator and vice president of sales at RedAwning.

“Amortization is crucial because it breaks down the fixed payments into interest and principal that decrease over time, so that the whole loan is paid off by the end of the term. Such a systematic process allows borrowing to be predictable for budgeting purposes,” he adds.

How does amortization work?

When you make payments on a loan, like a mortgage or auto loan, those payments are split between principal and interest. In the beginning, the majority of your payments will go toward interest.

“Interest payments are higher as you begin to pay back the loan strictly because of your balance,” says Jeremy Schachter, branch manager at Fairway Independent Mortgage Corporation.

“When you start making your loan payment, some goes to interest, and some goes to principal. As you slowly pay down the balance and principal, your interest will be less because interest is calculated based on the balance owed and not what you started with,” he explains.

Understanding an amortization schedule

An amortization schedule is a table that shows how a loan will be paid off — it's a breakdown of the monthly payments over the life of the loan. If you're wondering how to calculate amortization, it helps to look at an amortization table.

Here's an amortization schedule for a $400,000 mortgage with a 7% interest rate and a 10-year loan term:

As you can see from the table, the interest payments start off much higher and continue to decrease over the loan term. By the end of the loan term, the majority of your payments are applied toward the principal, with only a small percentage going toward interest.

Amortization vs. simple interest: What's the difference?

When you're applying for a loan, you might come across the term simple interest. With simple interest, you only pay interest on the initial amount borrowed, which means your interest payments stay the same over the life of the loan. In comparison, amortization involves payments that gradually put more toward principal and less toward interest over time.

You might receive simple interest on an auto loan, short-term personal loan, or student loan. Amortization schedules are used for loans that have compounding interest, like mortgages, car loans, and personal loans.

How to use amortization to your advantage

One of the best ways to take advantage of amortization is by making extra payments toward the principal.

“Even a small additional payment per month has a big impact on the principal, reducing interest overall,” says Bergeron.

However, if you choose this strategy, it's important to specifically mark the payment as going toward the principal.

“If this is not selected, it may be applied toward your next payment or your escrow account for taxes and insurance,” says Schachter.

Another way to use amortization to your advantage is by choosing shorter loan terms — for example, refinancing your 30-year mortgage to a 15-year loan term instead.

“The shorter the term of the loan, the less interest you pay on it,” explains Bergeron. “If you decide to take out a shorter-term loan, your amortization will be calculated on the new term, so your interest will be less.”