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.
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.
