What Is Amortization? How It Works and How to Calculate It

Ever wondered how you can efficiently manage your student loan repayments? Well, understanding the concept of loan amortization might be the way forward. By understanding these concepts, you can better plan your loan payments, and potentially save money on your student loans in the long run.

Key takeaways

• Amortization is the process of paying off a loan through fixed regular payments over time
• Each loan payment is split into principal and interest, with the majority of earlier payments going toward interest
• Making extra payments towards your loan principal can help you save big on accrued interest and reduce the loan term

What is amortization?

What is amortization? In simple terms, amortization is the process through which loan payments are spread out over time between the interest and principal. It involves making regular payments that gradually reduce the loan balance until it's fully paid off.

How does amortization work?

Amortization works on a predetermined schedule, starting with the initiation of the loan and ending when the entire loan is paid off. Let's take a look at an example to make it clearer:

• You borrow $40,000 in private student loans from a lender
• Your interest rate is 4.7% per annum, and you have a term of 10 years to pay off the loan
• Monthly, you would be required to pay roughly $418, which includes some interest and principal

This example shows us one aspect of amortization. You know the loan amount, the interest rate, and the term from reading the details of your student loan. Using an amortization calculator, you can accurately calculate your monthly payment. But, how does it break down each month?

What happens in each monthly amortization payment?

Every month, when you pay that $418, the money gets split into 2 parts: the principal and the interest. But don't assume that the split is always equal.

• The principal is the amount you originally borrowed
• The interest is the cost of borrowing the money

Let's look deeper into the first few years of an amortized loan:

• Your first few payments will consist mostly of interest payments and a smaller portion will go toward the principal
• As you continue to make payments, the interest portion decreases while the principal portion increases

Essentially, during the early stages of your loan, the bulk of your initial payments are interest. Only a small portion reduces your original borrowed amount.

Why does the majority of your payment going towards interest?

Every loan is "top-heavy" in terms of interest. As supporting evidence, the first payment of $418, around $157, goes toward the principal, and approximately $261 goes toward the interest. Yes, around 62% of your first payment ends up with the lender.

And the financial load lightens up as you continue along the amortization schedule:

• In the second year, you would have paid about $5,020 in total, with around $3,363 reducing your loan balance and $1,657 going toward interest.
• 10 years later, an even greater portion of your payment would be going towards the principal.

When I was younger and paying down loans, this felt really unfair. After all, why should so much of my payment go towards interest, rather than the principal I actually borrowed? But over time, I realized I was going to have to pay the interest at some point - so it was better to just get it out of the way early!

What can you do to decrease your principal faster?

However, you have the power to speed up the process. Making extra payments towards your debt is one way to save on accrued interest, potentially reducing thousands of dollars and shaving years off the life of your loan.

Let's say you decided to make an additional $100 per month payment on the initial loan we discussed.

• This would save almost $2,500 in interest over the life of the loan
• It would cut more than 2 years off the loan term

But bear in mind, going this extra mile might be a financial stretch for some people. If you can afford it, you'll be on your way to financial freedom sooner. The key is, extra payments should always go towards your principal, not the interest.

Amortization vs investing your extra money: which is better?

Paying off your loan faster can save money. However, there might be other strategies. Some finance experts argue it would be better to put your extra payment into an interest-earning account, especially if the interest rate on your loan is very low. Why?

Because after a certain point, you'd have enough to pay off the loan in one lump sum, and maybe even earn more than the interest on the loan. Deciding between these 2 paths will depend on the interest rate, your financial stability, and your risk tolerance.

Do’s and don'ts of loan amortization

Understanding the ins and outs of amortization can equip you with a powerful tool for managing and eventually eliminating your college loan debt. Let's see some crucial "do’s" and "don'ts" when it comes to your loan amortization.

Advantages and disadvantages of amortization

Every financial strategy has its pros and cons, and loan amortization is no exception. Let's look at the potential advantages and disadvantages of this strategy:

Advantages of loan amortization

• Predictability: Fixed monthly payments give you stability and help with budget planning.
• Lower payments spread over time: It makes big expenses manageable, which is especially helpful for students and parents in the early stages of their earning life.

Disadvantages of loan amortization

• More interest paid: Due to starting payments being interest-heavy, you might end up paying more over the life of the loan.
• Long-term commitment: A longer-term loan means you're bound to the loan for a more extended period. However, some loans don’t have early payment penalties, so you can always pay off sooner.
• Slow buildup: For a large part of the loan term, you aren't significantly reducing the principal sum, which could be a disadvantage for people trying to get out of debt quicker.

Remember, understanding amortization can be empowering. It's all about strategically managing your money and making informed decisions.

TuitionHero

At TuitionHero, we know college finance can be confusing, especially when it's about your hard-earned cash and future. That's why we're here to help students and parents like you with clear information about student loans and more.

Understanding loan terms, especially things like amortization (how it affects your interest and payments), can save you money in the long run. TuitionHero's Private Student Loan services and financial education can guide you through loan repayments and even refinancing options.

We want to give you the information you need to take control of your debt – and maybe even make you feel good about it!

Frequently asked questions (FAQ)

How does an amortization schedule benefit me?

An amortization schedule gives you a comprehensive snapshot of how each monthly payment reduces your loan balance over time. You'll get a clear insight into how much of your money goes into interest vs principal, enabling you to strategize on making extra payments.

How can I make extra payments on my loan amount?

You can make extra payments on your loan amount either by traditional mail or online. However, it's important to specify that these extra amounts go towards principal reduction to effectively lower your loan balance.

Is it worth making extra payments?

Yes, making extra payments can help you save a big sum in interest over the loan's lifespan, and potentially reduce the loan's term as well. But, always remember to thoroughly evaluate your financial situation before deciding.

Where else can I apply my extra money besides loan repayment?

If loan repayment doesn't seem like the best option for your extra money, consider investing it into an interest-earning account. Over time, this investment might give you enough returns to pay off your loan in a lump sum.

Final thoughts

Dealing with student loans and figuring out how they work can be a bit overwhelming, but it's okay – we're here for you at TuitionHero. Knowing more about your loans is key to making smart choices. It's like having a friend on your side! By making good decisions and handling your loan wisely, you not only keep more money in your pocket but also set yourself up for a secure financial future. Check out TuitionHero's Student Loan Refinancing options to make your loan work even better for you.

Source

• Amortization - Wikipedia
• Amortization Calculator