What is Amortization?
To make a big purchase like a home or a car or even to meet up certain personal commitments, we require lump sum amount. To get that money, most of us have to take a loan. When any loan is taken from bank or any other financial institution, it needs to be paid off over the period of time. The time period to pay off the complete loan as well as the amount to be paid over the period is pre-determined and mentioned in the terms and conditions of the loan. Paying off the loan over the scheduled period with equated payments or instalments at regular intervals is known as ‘Amortization’. It is the gradual decrease of a loan over the predetermined period of time.
Components of a Loan
- Principal Amount: When a loan is approved for a certain amount then that amount is known as ‘Principal’ in accounting terms. Principal is nothing but the amount that is borrowed.
- Interest Amount: When a loan is taken, it comes with a cost. That is the cost of borrowing. In accounting terms it is known as ‘Interest’. Interest is the amount charged on the principal and it is usually expressed in terms of percentage and on an annual basis. For example: ‘The interest is at 10% per annum’ means for borrowing every 100 Rupees, you have to pay additional 10 rupees per year as interest payment.
Loan Amortization Calculator
This is the calculator used to determine the Amortization schedule. Three parameters are needed to find the amortization schedule, these are: (1) Loan Amount, (2) Interest Rate and (3) Tenure of the loan. Based on the schedule of payments like monthly, quarterly or yearly payments, the number of payments during the entire loan period will be determined. The calculation generates a payment table which shows the amount of each periodic payment and the principal and interest components of each payment.
Since the monthly payment is the most common payment schedule, in our discussion we will assume the frequency of payments as monthly.
Loan Amortization Formula
Amortization Schedule is calculated based on this formula. The formula is as follows:
A = [i x P x (1 + i)n] / [(1 + i)n -1]
Where,
A = Periodic Payment Amount
P = Principal Amount
i = Interest rate
n = Total Number of Payments
Notes:
- Since interest is taken at annual rate and the formula is for each periodic payment, so, to use this formula ‘i’ should be in terms of periodic payment. That is, if you are calculating monthly payment then ‘i’ should be taken as ‘Interest Rate/12’
- In case the loan is for 2 years and the payments are to be made monthly, then n will be equal to: 12 x 2 = 24
Based on the above formula, the automated Amortization Calculator can be used to understand the entire Amortization Schedule.
The process of Loan Amortization – How it works?
As we start paying the loan, the principal amount at any point of time is the ‘loan balance outstanding’. Outstanding balance does not include the ‘interest’ component.
- When a borrower approaches for a loan, three things have to be decided first. The loan amount, the loan period and the interest rate.
- Once these things are agreed upon, a payment schedule is decided where the entire payable amount including principal and interest is divided into Equated Monthly Instalments (EMI).
- The payment schedule for the entire loan period is known as Amortization Schedule.
- Once the borrower starts the payment of EMI, loan amortization begins and the process continues until the entire debt is paid off as per the amortization schedule.
Amortization Schedule
Loan Amortization Schedule is a chart or a table which shows each payment (EMI) for the amortization of a loan. Each EMI consists of principal and interest components. Even though the monthly payment remains fixed, the components (principal and interest) change in every payment.
When the amortization schedule begins, a major part of the monthly instalment goes towards the payment of interest. Only a negligible amount is paid towards the principal that is borrowed. As more and more payments are made, the interest component of the equated monthly instalment goes down and more principal amount gets paid. Towards the end of the amortization schedule, majority of the payments are made to pay off the principal and very less amount is there as interest component.
Over the internet there are many free sites available where you get Amortization Calculator and on almost banks and financial institutions websites, you can find Loan Amortization Calculator. Those sites will display the amortization schedule for you once the necessary information of the loan is typed in the calculator.
Amortization overview and schedule were generated when the following data was input in the Amortization calculator in a free site available in the internet.
Example of Amortization with Following Input Data
Loan Amount – Rs. 1,00,000
Loan Tenure – 24 Months (many calculators will have option of month or year and you can input your data as per your convenience. In either case, the calculation will be done for monthly payment)
Interest Rate – 8% (Interest rate is put as the annual rate and the Amortization Calculator converted it into monthly rate automatically)
An Amortization Overview is obtained as follows:
| Payment Duration | 24 Months |
| Calculated Monthly EMI | 4,522.73 |
| Total Amount with Interest | 1,08,545.52 |
| Annual Interest Rate | 8% |
| Periodic Interest Rate | 0.6667 % |
| Total Interest Amount | 8,545.52 |
This table indicates the monthly payment that has to be made for the loan is 4522.73. It also indicates that for a loan of Rs. 1,00,000, the borrower will end up paying a total of 1,08,545.52 out of which 8,545.52 is the total interest paid over the period of 2 years.
A partial view of the Amortization Schedule for the above loan is shown below:
| Month & Year | Starting Balance | Interest Paid | Principle Paid | EMI | Ending Balance |
| Jan 2018 | 1,00,000 | 666.67 | 3,856.06 | 4,522.73 | 96,143.94 |
| Feb 2018 | 96,143.94 | 640.96 | 3,881.77 | 4,522.73 | 92,262.17 |
| Mar 2018 | 92,262.17 | 615.08 | 3,907.65 | 4,522.73 | 88,354.52 |
| Apr 2018 | 88,354.52 | 589.03 | 3,933.7 | 4,522.73 | 84,420.82 |
| May 2018 | 84,420.82 | 562.81 | 3,959.92 | 4,522.73 | 80,460.9 |
| Jun 2018 | 80,460.9 | 536.41 | 3,986.32 | 4,522.73 | 76,474.58 |
| … | … | … | … | … | … |
| … | … | … | … | … | … |
| Jun 2019 | 30,831.48 | 205.54 | 4,317.19 | 4,522.73 | 26,514.29 |
| Jul 2019 | 26,514.29 | 176.76 | 4,345.97 | 4,522.73 | 22,168.32 |
| Aug 2019 | 22,168.32 | 147.79 | 4,374.94 | 4,522.73 | 17,793.38 |
| Sep 2019 | 17,793.38 | 118.62 | 4,404.11 | 4,522.73 | 13,389.27 |
| Oct 2019 | 13,389.27 | 89.26 | 4,433.47 | 4,522.73 | 8,955.8 |
| Nov 2019 | 8,955.8 | 59.71 | 4,463.02 | 4,522.73 | 4,492.78 |
| Dec 2019 | 4,492.78 | 29.95 | 4,492.78 | 4,522.73 | 0 |
| TOTAL PAYMENT | 8,545.52 | 1,00,000 | 1,08,545.5 | ||
| YOUR LOAN PAY OFF DATE – Dec 2019 | |||||
This schedule breaks down payment of principal and interest for each payment. Also in the last column it shows the ‘Ending Balance’ after each payment is made. ‘Interest Paid’ component decreases with each payment while ‘Principal Paid’ component increases with each monthly payment is made.
Finally, when we take a loan and make regular payments towards it, it is a good idea to take help of an amortization calculator to find out how the payment works in the long run. It is surprising to see that over the period, a big amount gets paid towards interest and the higher the tenure of the loan, the more is the interest component that a borrower has to pay.