What is amortization?
As an investor, you might need to pay debts in installments. That’s called amortization. Let’s say that you take out a home loan to expand your real estate portfolio. Your lender will spread out the amount you owe into a series of fixed payments that reflect the total amount of the loan and interest on that loan. You make those payments until you pay off the entire loan—known as the end of the payment schedule.
Your lender will provide you with something called an amortization table when you take out a loan. (It will look like a long spreadsheet that spans several pages.) It lists each repayment you need to make every month and how much of those payments go toward interest or the loan itself. Your total repayments will probably be for the same amount every month, but you’ll notice that different amounts go toward reducing the loan (aka principal) and the interest on the loan. More of your repayment might go toward interest when you first take out the loan, while near the tail-end of your loan, you’ll be paying down the principal.
Amortization is beneficial because you can determine how much of your monthly repayments go toward interest on your loan. Lenders only advertise the total repayments you make each month without breaking down this information. You can learn, for example, whether you will end up paying more interest over time because a loan has a long repayment term. Or you can use amortization to compare different loans on the market and make smarter investment choices.
Lenders use this calculation to work out amortization:
TMP − (OLB × (interest rate / 12 months))
TMP stands for the total monthly payment; OLB stands for the outstanding loan balance.
Say you take out a 20-year home loan for $500,000 (outstanding loan balance) at a five percent interest rate with a total monthly payment of $3,300. You divide the 5% interest rate by 12 (0.00416) and multiply that amount by the $550,000 outstanding loan balance. For the first month, you will pay $2,292 in interest. The rest of your total monthly payment ($3,300-$2,292=$1,008) will go toward paying the loan.
Amortization case study
Jasmin wants to purchase a second property and expand her investment portfolio. She inquires about a loan with her bank. The bank says it will spread out her loan repayments over 30 years into monthly fixed installments. An amortization table tells the investor how much of her monthly repayments go toward interest and how much reduces the amount of the loan. She realizes she will pay too much interest on that particular loan so chooses a loan with a shorter repayment term.
The bottom line
Amortization is an accounting technique that spreads out a loan into fixed repayments. Those repayments relate to the amount of the loan and interest on the loan. Amortization helps you work out the percentage of your repayments that reduce the loan and the percentage that goes toward interest on the loan. That can help you compare different loan options and choose the best financial products; not all loans are made the same, even if the monthly payment is similar.