How Amortization Works

Most people who have accumulated debt will typically make payments on that debt every month based on the principle of amortization. This is a fancy term that simply means the payment that is being made by a borrower includes various parts and is the same each month. One part of a monthly payment is the cost of interest and the other is payment of principal.

Anyone buying a house or getting a loan to buy a car will be making an amortized payment. Payments will stay the same each month through the life of the loan. However, a loan payment which includes any taxes and insurance payments can change slightly from year to year. The interest costs of a loan will typically be the highest at the start of the loan. This is especially true for a mortgage or other long-term loans. As you only pay off a small amount of principal with each payment.

Interest payments go down with each payment until you eventually pay for towards the principal of the loan. If someone has a 30-year mortgage, they will make 360 monthly payments. The last payment will pay off the loan and leave no outstanding balance. Something that many people often do when they are trying to reduce their monthly payment is refinance to a lower interest rate. This is just one of the ways borrowers have to manage their debt.

There are typically three types of loans that are amortized or are paid in installments. Any loan that can be paid in installments is typically amortized. This includes auto loans, home loans, and personal loans from a bank or credit union.

Auto Loans

Paying cash for a new car is not usually something someone can afford to do. Most people will require an auto loan to get the kind of car they prefer. Most auto loans are five years, but longer terms are available too. The downside to a longer loan period is you will be paying more in interest.

Home Loans

Traditional home loans or mortgages are at a fixed rate of 15 or 30 years. Mortgages are also available with additional options and with a variable rate. However, people who have high interest rates often refinance to a lower rate to get a lower payment or may choose to sell their home at some point.

Personal Loans

Loans that are available from a community bank, a national bank, or from local credit unions are also typically amortized. They have a fixed rate and a fixed payment per month. Many loans like these are typically offered in a range of three to four years. Some people use short-term loans as an option for managing debt or to do a project around the house.

Another way that amortization can be seen is the way taxes are calculated for the IRS. Interest on many types of mortgages and be deducted on a tax return. Property taxes that are paid may also be deducted if a borrower has the option to do so. Keep in mind that certain deductions taken on a tax return may mean an individual has to itemize their deductions.

Borrowers should also know that certain types of loans are not amortized. Revolving debt like balances on credit cards can have different payments applied. An interest only loan is also not amortized, at least not during the period where “interest only” is paid as there is no principal payment.

Individuals will need to take a look at their personal finance situation to determine the types of debts they have if they want to avoid “drowning” in debt. Knowing how amortization works is a big help when looking at buying a house for the first time or taking out an auto loan to buy a new car. Talking to someone who is a financial planner or tax specialist, to get an idea of what to expect, is always worthwhile.