Understanding the cost of borrowing: What is amortization and why it matters

Have you ever wondered how much you spend on interest? Thanks to an accounting concept known as amortization, finding out may be easier than you realize.

Mortgages, auto and personal loans are some of the most common amortizing loans. They can all be paid down over a set period of time. Even better, they can be broken down into a simple payment schedule.

What is amortization?

Amortization describes a subtle change in your loan payments over time. The cost of your monthly payments stays consistent. However, the monthly cost of interest gradually decreases from month to month. This happens because interest rates are calculated based on your loan balance, not your monthly payment. As you pay off your loan, the balance steadily decreases along with the monthly cost of interest.

Spending less on interest leaves you with more money to cover the true cost of your loan – the principal. With every passing payment, a smaller portion of your total payment pays for interest, while a larger portion pays for the principal. This inverse relationship is amortization at work.

Let’s consider a $300,000 mortgage paid over 30 years. At an interest rate of 5%, your monthly payments will be $1,610.46. For the sake of simplicity, tax and insurance costs are not included in these calculations.

Here’s how the numbers play out over ten months:

Notice how the principal increases with every payment, while the monthly cost of interest decreases. Also, notice how much of your total monthly payment goes toward interest each month. It’s a lot! For most mortgages, interest may make up the bulk of your payments for several years.

Why does amortization matter?

Amortization shows us the true cost of borrowing. With an amortization schedule like the one shown above, it’s easy to see exactly how much you owe in interest. A quick look at your cumulative cost of interest can be eye-opening.

Amortization also calls attention to the benefits of paying off debt early. When you pay more than you owe each month, you can quickly lower your loan balance, and therefore decrease your total cost of interest.

Consider our previous example of a $300,000 mortgage at 5% interest. If you pay the minimum monthly payment for 30 years, your cumulative interest will total $279,767. Here’s what your amortization schedule will show for the final months of your mortgage:

But what happens if you pay an extra $50 every month? Let’s adjust our amortization schedule to find out.

Not only does your loan term shorten by 23 months, you save $21,662.67 in interest. That’s a lot of hard-earned money!

Amortization schedules are decision-making tools

Amortization schedules are a valuable source of knowledge. With a few easy calculations, you can see your principal, monthly interest and cumulative interest at year one, two, 10 or 20. Plus, an amortization schedule can calculate how much you save by paying over the monthly minimum.

If you’re in the market for a loan, consider using a schedule to compare borrowing options. Doing so will help you understand what you’re signing up for. For example, you may be tempted to choose a loan with low monthly payments and higher interest rates. This often seems like the more affordable option, but in reality, the cumulative cost of interest may be quite high.

Create a schedule for your loan

Creating an amortization schedule is as simple as plugging in a few numbers. Get started with Excel’s built-in amortization templates. Or, just browse online where you’ll find a variety of calculators to help you see numbers more specific to your situation.

If you have questions about amortization, we’re here to help. Make an appointment with us today.