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:
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.
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.
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.
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.
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.
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.
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.
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.
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