| Know It Olly

TL:DR Amortization is the planned process of paying for something, like a house, in regular, even amounts, usually on a monthly basis, until the total cost is paid off.

Free Excel/Google Sheet Amortization Template

Understanding amortization is important because it can help you make better decisions about loans and big purchases. In this article, we’ll break down what amortization means, how it works, why it’s important, and how it affects both you and the banks. We’ll keep things simple, so it’s easy to follow along.

The Basics of Amortization

Amortization is all about making big purchases more manageable. When you buy something expensive, like a house or a car, you usually can’t pay for it all at once. Instead, you borrow money, and then pay it back little by little over time. Each payment you make has two parts: one part goes toward paying off what you borrowed (the principal), and the other part goes toward paying the fee for borrowing the money (the interest).

How Amortization Works

When you borrow money, you agree to pay it back over a certain period, like 10, 20, or 30 years. This period is called the loan term or amortization period. During this time, you make regular payments that cover both the interest and the principal.

In the beginning, most of your payment goes toward interest which is how banks make their money. But as you keep paying, the balance you owe gets smaller, so the interest you pay also decreases. This means that more of your payment goes toward paying off the principal, and you get closer to owning your home or car outright.

Amortization Schedule Example

To see how this works, imagine a $100,000 loan with a 12% interest rate(1% per month for simplicity) paid over 100 months. Your monthly payment might be around $1,451.34. At first, most of this payment goes to interest, but by the end of the loan, most of it goes to paying off the actual loan.

As you can see from this schedule, payments are always the same. However, the amount you pay in interest at the beginning is double the amount you are actually putting towards the loan amount(principle). This is how banks make their money at the beginning of the loan period and why constant remortgaging can actually harm your finances while giving the bank even more profits.

In these final months, you can see that most of your payment goes toward paying off the principal, with only a small amount going toward interest. By the end of the 100th month, the loan is fully paid off, with no remaining balance.

Types of Amortization

There are different ways to structure amortization:

Straight-Line Amortization: This is the most common method, where you pay the same amount each month, and the cost is spread evenly over the life of the loan or asset.
Declining Balance Method: With this method, you pay more at the beginning and less later on. It’s often used for items that lose value quickly, like cars.
Balloon Payments: Here, you make smaller payments during the loan term, but at the end, you have to make one large payment. This can be risky if you’re not prepared for that big payment.

Each method has its pros and cons, depending on your financial situation and the type of loan you have.

Amortization vs. Depreciation

Amortization and depreciation are similar, but they apply to different things.

Amortization is used for intangible assets (things you can’t touch, like patents or copyrights) and for loans. It spreads the cost over time, reducing the value little by little.
Depreciation is used for tangible assets (things you can touch, like cars or buildings) that lose value over time. Depreciation also spreads the cost over the asset’s useful life.

Both amortization and depreciation help businesses and individuals manage their money better by showing how much value is being used up over time.

How Banks Benefit from Amortization

Banks make their money by charging interest on loans. When you take out a loan, the bank charges you interest, which is like a fee for borrowing their money. At the beginning of your loan, most of your payment goes toward paying this interest, so the bank earns more money in the early years.

In some places, like Canada, people are required to remortgage their homes every 5 years. Remortgaging means taking out a new loan to replace the old one. While this can sometimes help you get a better interest rate, it often benefits the bank more than you. That’s because when you remortgage, you start the loan process over, and once again, most of your payments go toward interest. This means it takes longer for you to build equity (ownership) in your home, and the bank continues to earn a lot of money from the interest.

The Pros and Cons of Amortization

Pros:

Affordable Payments: Amortization makes it possible to afford big purchases by spreading the cost over time.
Predictability: You know exactly how much you’ll pay each month, which helps with budgeting.
Tax Benefits: In some cases, you can deduct interest payments on your taxes, which can save you money.

Cons:

Interest Costs: Over time, you pay more because of interest, especially in the early years of the loan.
Long-Term Commitment: Being locked into payments for many years can limit your financial flexibility.
Loss of Income: What happens if, 10 years from now, you lose your job and are unable to make the payments?

How to Make Smart Decisions with Amortization

To get the most out of amortization, it’s important to understand your loan and how it works. Here are some tips:

Paying Extra: If you can afford to, make extra payments. This can reduce the amount of interest you pay over time and help you pay off the loan faster.
Be Careful with Remortgaging: Before remortgaging, think about whether it’s really the best option for you. While it might lower your monthly payments, it could end up costing you more in the long run.
Understand Your Loan Terms: Make sure you know how much of each payment goes to interest and how much goes to principal. This can help you see how quickly you’re paying off your loan.

Conclusion: Amortization Is a Tool—Use It Wisely

Amortization is a helpful tool that makes it possible to buy big things, like homes and cars, by breaking down the cost into manageable payments. However, it’s important to understand how it works so you can make smart financial decisions. By paying attention to how much interest you’re paying and being careful with remortgaging, you can keep more money in your pocket and build your wealth over time.