How do Amortization and the Repayment Schedule Work

Understanding Repayment Schedule: How Does Amortization Work

When you take out a loan for any purpose, you have to pay it all back.

How you pay back the loan is a significant part of the loan paperwork. The table that is used for stating how much you should pay is called the amortization schedule.

The amortization schedule is a record of your loan payments and includes:

  • The number of payments,
  • The payment date,
  • The amount of the payment,
  • The balance owed after the made payment.

Some Key Amortization Schedule Terms

  • Rate: this is the percentage that the lender charges when they offer the loan. These rates can be variable rates, which can change throughout the life of the loan, or fixed rates which will always stay the same. A rate can be a flat, nominal interest rate, or it can be compounded monthly or semi-annually.
  • Interest: The monthly amount the lender charges to lend the money. Even if you pay the same amount each month, the amount of each payment that will go to pay interest will change every month. It will go down, as the size of the outstanding principal is reducing each month.
  • Insurance: This is primarily part of a mortgage, but some other types of loans may require insurance payments, which protect the lender should an impediment develop that makes it difficult to pay the loan, or there is damage to loan collateral.
  • Total Payment: This is everything you need to pay, including the principal amount, interest, fees, and other charges.

Amortization – The Guidelines to Paying Back a Loan

Perhaps you have taken out a loan and wonder why paying your loan on time doesn’t seem to make a significant dent in the principal amount for the first few months to a year. There is a reason for this.
How Does Loan Amortization Work

Specifics of the Initial Period

At the front end of the amortization schedule, a large portion of the total payment goes to paying fees and interest on the loan, with the remainder going to pay down the principal balance. This breakdown of payments can be seen in your amortization schedule.

Rely on Your Amortization Schedule

Consider the amortization schedule on any loan as something resembling a road map for making sure you pay back the loan on time. It provides the borrower with all the information needed to stay on track and pay back the loan on time.

Here’s a Relevant Example

For example, say you borrow $10,000 from a lender, and the lender offers to loan you the money at a 12% effective interest rate (EIR), and you agree to pay $350 per month. Now, a 12% EIR is easy to understand because it comes to one percent per month. The amortization schedule will show how much of each $350 payment will go to pay for interest and fees, and how much will be applied to reducing the $10,000 principal.

Specifics of the Last Period of Debt Repayment

It will also show the balance you owe from the principle. That last number is significant because the lender will apply the interest rate to that remaining balance. In the first month, for example, the interest owed in the first month will be $100 (one percent of $10,000), so the other $250 will be applied to the interest. Subsequently, the next month’s interest will be $97.50 (one percent of $9,750), and the rest of that $350 payment will be applied to the principal balance.

Remember
Whereas the periodic payment is the same amount throughout the schedule, the portion of the payment that goes to interest is much more substantial at the beginning than it is later on. At first, a large part of the payment amount goes to interest, but that amount diminishes over the length of the loan. At the same time, the remaining balance goes down at a faster rate as the loan is repaid.

Why Paying on Time is Critical

Paying your loan on time every month is important. We used a simple, effective interest rate, which is a simple way to compute interest every month, but lenders often use compound interest, which means, when a loan payment is due at a particular period and is paid on time, the interest calculation is based on the lower amount due.

What Happens if a Payment is not Made

However, when you fail to make a timely payment, that calculation will be made on the entire amount, including the interest payment that should have been received on time. And that doesn’t include any late payment fees that may be charged to the account, or any increased interest that may take effect with a late payment.

There is also a possibility that, if the amount of the payment isn’t enough to cover all the late charges and anything else that may be added, the lender will produce a negative amortization schedule, in which the principal balance may start to increase, rather than decrease. If you were scheduled to pay off the loan in three years, you might find that time frame increasing.

Keep an Eye on the Payback

While you may be borrowing money for a useful purpose, like a car, a vacation or even a home, it is always helpful to remember that, in the long run, paying it back is often the most crucial aspect of your loan.

Tip
Before you sign for the loan, examine the amortization schedule thoroughly and make sure you know what you are getting into. Make sure the monthly payment fits your budget and that you can pay on time every month.

Works Cited

1 Investopedia “Amortization Schedule” https://www.investopedia.com/terms/a/amortization_schedule.asp

2 The Balance “Interest Rates and How They Work” https://www.thebalance.com/what-are-interest-rates-and-how-do-they-work-3305855

3 The Advantage Blog “What Happens When You Pay Off A Loan Early?” https://www.advantageccs.org/blog/what-happens-when-you-pay-off-a-loan-early


Was this post Helpful?
1 0