Have you ever made a payment on a loan, and wondered how your amount due was calculated? Most clients I worked with understand that some of their payment goes towards principal, and some goes towards interest. Exactly how much and what calculation is used is often less clear. For every loan is different, we can help you understand how much you're paying an interest, and why is learning how a loan is amortized. In this lesson, you'll learn what debt amortization is and how it impacts your bottom line. You'll understand how different types of loans tend to be amortized and be able to explain how loan interest is calculated. The concept of amortization is the idea that you can spread out payments over time, that would include both principal and interest. This will be relevant for any types of installment debt that you have, which are debts that are paid back over a fixed period of time, like student loans, car loans, and mortgages. An amortized loan is one that uses any payment to first pay off accrued interest, then the remainder of the payment goes towards principal. This means that at the beginning of the loan when the outstanding balance is the highest and more interest is occurring, more of your repayment goes towards interest than subsequent payments. As time goes on and principal is paid down, less interest accrues between payments, and more of each payment is able to go towards principal. Let's go over a quick example. Let's say you take out a loan for $10,000 at a five percent interest rate over three years. This installment loan would have a total of 36 payments, one for each month for three years. We'll use a simple interest calculation for this example, meaning interest will only accrue on the balance each day that the loan is outstanding. The payment on this loan will be the same every month for all three years, $ 299 and 71 cents per month. The first month when you owe $10,000 , interest accrued will be $ 41 and 67 cents, so of your $299 and 67 cents payment, $ 41 and 67 cents will go towards interest to pay that off in full. Then the remainder of your payment, which is $258 and four cents, will go towards principal. Now, your outstanding principal balance is $ 9,741 and 96 cents and your five percent interest will be calculated off of this amount. This means that for month number two your interest accrued will be $40 and 59 cents less than what was accrued the first month. Remember, your payment is exactly the same every month. You pay $299 and 71 cents again, but only $40 and 59 cents goes towards interest since that's all that is accrued and the remainder, $259 and 12 cents will go towards principal, a larger principal payment than the month before. This trend continues for the life of the loan, and gradually the amount of interest paid each month is less and less so more of your monthly payment goes towards principal until the entire loan is paid off. This is the concept of amortization. Now, let's talk about a less desirable borrowing experience, what is called negative amortization. You now know that amortization means you would pay off a loan with regular monthly payments, and the amount you owe would go down with each payment. Negative amortization though is when you make your payment, but the payment is not enough to cover the amount of interest accrued. The amount you owe will actually continue to go up each month. Scary. for this isn't something you will encounter often, It's important to be aware of the concept and that these loans do exist. Many student loan borrowers may experience negative amortization, shortly after graduation when their student loans are at their highest and their payments are low. Let's talk through an example. Let's say you went to school and took out $60,000 as student loans at six percent interest. You have 10 years to repay the loans and in this case, the monthly payment would need to be about $666 in order to pay the loan off in full and on time. However, like many new grants that may be an unrealistic sum, so you opt for an income-driven repayment plan that is more affordable and you agree to pay $200 a month until your income increases. Well, your $60,000 loan at six percent interest, will accrue $300 in interest the first month. If your payment is only $200, not only did you not contribute anything towards the principal, you also have a larger outstanding loan amount than you did before because of the additional accrued interest of $100 you haven't paid yet either. You started out with $60,000 and accrued $300 in interest the first month, owing $60,300. You made a payment of $200 and your new loan balance is $ 60,100. Now on month two, your six percent interest on $60,100 is $301 of interest for the second month. If you pay your minimum monthly payment of $200, and it all goes towards interest, then your balance grows again, this time by $101 for a total of $60,201 outstanding. This is the concept of negative amortization. While there are some regulatory controls in place to help avoid predatory lending that would result in these types of loans, negative amortization can still happen. The best way to avoid negative amortization is to make sure you're always paying at least enough to cover accrued interest with each payment. As I mentioned, amortization is simply the calculation of your payments, of principal, and interest over the life of an installment loan. In the cases of shorter-term loans like car loans, which are typically five years, the calculations may seem fair and you can start to see your principal being paid down fairly quickly. In the case of longer-term loans however, like a 30-year mortgage, there are significantly more years worth of interest calculated and therefore, the interest payments each month for the first few years is very high. In many cases higher than the amount that goes towards principal, this doesn't mean that you have a bad loan, it's just the nature of borrowing a large amount of money over a long period of time. While you can't change the nature of loan amortization by understanding how it works, you are now better prepared to navigate borrowing and repayment.