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What is Amortization?

Monthly mortgage payments are a common type of amortization.
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  • Written By: Sherry Holetzky
  • Edited By: L. S. Wynn
  • Last Modified Date: 06 July 2014
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The process of paying off a loan through specifically structured periodic payments is known as amortization. This type of loan is different from other loans due to the way the amount and the structure of each payment is determined.

Mortgage payments are a common form of amortized loans and, interestingly enough, both the terms "mortgage" and "amortization" find their meaning in the same root word: "mort." This term means to deaden or kill, as in to "kill off" or eliminate the loan a bit at a time, via regular payments. Regarding home loans, payments are usually the same amount each month with a fixed interest rate. In some cases, the last payment may be a bit more or a bit less than payments made throughout the life of the loan.

Amortized payments are calculated by dividing the principal — the balance of the amount loaned after down payment — by the number of months allotted for repayment. Next, interest is added. Interest is calculated at the current rate according to the length of the loan, usually 15, 20, or 30 years. Each payment eliminates a percentage of the interest first, and then a portion of the principal.

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Some people confuse these loans with interest-only loans. In an interest-only loan, the entire amount of the scheduled payment goes to the interest due on the loan rather than towards the principal. Borrowers may, however, make additional, specific principal payments. These loans can be beneficial because they generally allow for smaller payments. With an amortized loan, it is true that the largest part of the payment goes toward interest — at least at the beginning of the loan — but a portion of the principal is in fact, paid down as well.

In most this type of loan structure, it can take at least half of the life of the loan or longer for the interest and principal payment amounts to become equal. Eventually, the amount of principal being paid off starts to outweigh the amount of interest, depleting the balance more quickly.

Many people choose to pay an additional amount each month and apply that amount to the principal balance. Since interest is a product of the principal multiplied by the interest rate, the lower the principal is, the lower the interest payment will be. Making additional or larger payments each month helps save money in the long term and reduces the life of the loan. It is important for borrowers to make it clear to the finance company that the additional sum should be applied directly to the principal.

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Discuss this Article

anon352863
Post 6

@bpotts: It depends on the type of loan. All mortgages in the US are "simple interest" loans, i.e., they don't accrue interest on interest, just on the principal. There are two regularly used types of loans in this category. The majority of mortgages are monthly simple interest (also just known as a standard loan). What this means is interest is only accrued once per month (take the UPB at the end of the billing cycle and multiply that by your interest rate, then divide by 12 to determine interest accrued)

The other type is a daily simple interest, sometimes called a DSI. These are based on the actual number of days in the given time frame, so in a leap year, interest is accrued 366 times, while any other time it is accrued 365 times.

On a standard loan, the amount going to the principal is very straightforward -- every month will be slightly more than the previous month. With a DSI, you have a lot of other things that need to be factored in, including the day the previous month's payment was posted to the account, the day the current month's payment is posting to the account and the number of days in the month.

anon34351
Post 5

I'm not 100% sure but im fairly certain French has been derived from Latin in which mort means death.

bpotts
Post 3

When figuring a payoff on an amortized loan, how is the interest figured? Is it on a 365 day basis?

anon13452
Post 2

Great help to me this, thanks, they are basically repayment loans in their common term in England....

anon11662
Post 1

the root word 'mort' is french for dead, not to kill, as in "he is dead"..."il est mort". to kill is the verb tuer. real estate meant royal estate back in the day. to have a mortgage on a piece of property that a duke or prince owned meant to literally sign your life away. a gauge on your life or death so to speak. it puts a different spin on the mortgage n'est-ce pas?

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