What is Amortization?
Amortization, from a financial perspective, refers to the process of paying off a debt (often from a loan or mortgage) over time through regular payments. A portion of each payment is for interest while the remaining amount is applied towards the principal balance. The percentages of payment that go towards principal and interest, however, vary with each period.An amortized loan is a loan that is paid off (both interest and principal) in a series of even, regular payments. The core concept that governs financial instruments such as these is the time value of money, and thus, the loan amortization is strongly connected to the present and future value of money.
How to use Amortization Calculator?
To use an amortization calculator, you typically need three key pieces of information:
The loan amount or principal
The annual interest rate
The repayment term, or how many years it will take to pay off the loan
Once you input the required details, the calculator allows you to view a summarised repayment schedule. This schedule shows how the payments are divided between the interest (computed from the outstanding balance) and the principal over the loan's life.
An Actual Example to Demonstrate the Calculator
Consider you borrow $1,000 to repay in five equal parts at the end of every year. The amortization term, therefore, is five years with a yearly payment frequency. The lender charges a 12 percent interest, calculated on the outstanding balance at the start of each year (yearly compounding).
To find the annual payment (PMT), we need to equate the sum of the present values of these future repayments with the loan amount: $1,000. Such computation involves complex calculations, but using a calculator makes it easy. When you input these parameters into an amortization calculator, you find that the annual payment is $277.41.
This calculation gets shown in the amortization schedule, which shows how the annual payments get divided between interest and principal. At the beginning of the loan term, most of the payment goes towards interest, with a comparatively smaller portion for the principal. As the payment process progresses, the unpaid balance declines, which gradually lowers the interest obligations, making more room for principal repayment.
The higher the weight of the principal part, the faster the rate of decline in the unpaid balance. The important thing about such a schedule and understanding it is it shows how much you pay in interest for your loan and when exactly your loan gets paid off.