What is amortization?

From http://www.bankrate.com

You can define the term easily if you have a solid education in the basics of finance. You probably know what it is if you've bought a house once or twice. Or maybe you know sorta, kinda what "amortization" means, but not really. For an explanation, let's turn to experts who promise not to bore you to tears.

First up, we have Philip Russel, assistant professor of finance at Philadelphia University, who defines amortization as "the systemic payment plan -- such as a monthly payment -- so that your loan is paid off over the specified loan period."

So an amortized loan is for one specific amount that is to be paid off by a certain date, usually in equal monthly installments. Your car loan and home loan fit that definition. Your credit card account doesn't because it's a revolving loan with no fixed payoff date.

That's only part of what lenders mean when they talk about amortization.

Chris Edwards, manager of the business-to-consumer Web site for IndyMac Bank Home Lending, a mortgage lender, points out that "amortization" arises from a Latin term that means "to deaden," and that a common dictionary definition includes the phrase "gradual extinguishment."

"This term sounds about as fun as a 'pre-need' funeral service sales presentation," he e-mails.

(By the way, the word "mortgage" has the same Latin root, and literally means "dead pledge." The property is "dead" to the borrower if he defaults on the debt, and the pledge is "dead" to the lender after the loan is repaid. That's how people coined words in the 14th century.)

Amortization is less about death than about shrinkage (or "gradual extinguishment").

"A part of the payment goes toward the interest cost and the remainder of the payment goes toward the principal amount -- the amount borrowed," Russel says. Interest is computed on the current amount owed "and thus will become progressively smaller as the ending balance of the loan reduces." See? Shrinkage.

Back to Edwards: "If you've ever had a mortgage, you'll know that you seem to pay a lot toward interest and not much toward the principal balance for the first several years of your loan," he says. "This isn't a complex financial scheme dreamed up by gray-suited bankers in an underground conference room, but rather simple mathematics."

Take a mortgage loan for $100,000 at 6.5 percent for 30 years. The monthly principal and interest payment is $632.07. For the first month, you owe interest for $100,000, which equals $541.67. The remainder of the payment, $90.40, goes toward principal. In other words, your debt is reduced by $90.40.

"Next month, you only owe interest on $99,909.60, so $541.18 goes to interest and $90.89 goes to principal," Edwards says. "Month after month, your interest portion will decrease a bit and your principal reduction will increase. This process continues until your 360th payment contributes $3.41 to interest and $628.66 to principal."

You can see how this works by consulting Bankrate.com's mortgage calculator, which lets you type in any mortgage amount, interest rate and term, or length of loan.

The calculator gives you the option of looking at an amortization table, also known as an amortization schedule. This table tells how much interest and how much principal is included in each monthly payment, from the first to the last.

In the above example, "you'll be delighted to see that after 256 payments, you've paid off about half of your loan," Edwards says. That's 21 years and four months. You pay off the other half of the principal in the remaining eight years and eight months.

Now, if the loan above amortized for 15 years instead of 30 years, the monthly principal and interest would cost $871.11.

In the first month, you still would pay $541.67 in interest because the amount of the loan is the same and the interest rate is the same. But you would pay $329.44 in principal with that first payment because you're paying off the loan quicker.

"OK, so it's not simple mathematics, but it's not exactly deadening either," Edwards says.

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