When you pay off a loan in equal installments, the calculation that is used to figure out what you owe the lender is called amortization. To ensure that the lender gets as much of your money up front as possible, loans are structured so that you pay off more of the interest owed early in the loan. As the years go by, you increase how much of the principal you pay off. By the end of the loan term, if your loan is fully amortizing, then both the principal and the interest will be paid off.
Understanding a Loan Amortization Calculator
You can use a loan amortization calculator to spell out payments using a loan amortization schedule, which shows how much interest and principal you will be paying off each month for the term of the loan.
For example, consider a $200,000 mortgage for a term of 30 years at 4.5% interest. After 36 months of paying off your mortgage, you still owe $189,869. You’ve paid the lender $36,481 but only knocked $10,131 off your debt. That’s how amortization works. The monthly payment on that 30-year loan was $1,013.37. It will cost $164,813.42 in interest by the time it ends in 30 years.
Knock the loan term back to 15 years, and your monthly payment will be $1,529.99. But when the loan ends in 15 years, you’ll have paid just $75.397.58 in interest, a savings of $89,415.84.
These are the discoveries that you can make using a loan amortization calculator. Play around to see which loan term length turns out to be the sweetest deal for your circumstances. If, for example, you know that you will sell the house in three years when your company relocates you, then it may make sense to choose the longest term so that the monthly cost will be the smallest. You won’t be around long enough for the difference in equity to matter that much. If, on the other hand, you think that you’re buying your forever home—or interest rates are particularly low—then it will pay to take on the shortest term you can afford and pay off the loan as quickly as possible.
Which Loans Get Amortized?
There are many types of loans, and they don’t all have amortization. Loans for major purchases such as cars, homes, and personal loans often used for small purchases or debt consolidation have amortization schedules. Credit cards, interest-only loans, and balloon loans don’t have amortization.
Amortization, if your loan is fully amortized, is a way to ensure that your loan will be paid off completely at the end of your loan payments. Before you sign on to a loan that doesn’t have full amortization, think through the consequences carefully and make sure that you will be able to pay off your loan without it.