Loan Amortization 101

Why Your Loans Are Front-Loaded with Interest Payments

Loan Amortization 101
June 23, 2014

A loan amortization schedule lists your mortgage payments as well as the amount that is devoted to interest and principal. These numbers are important, because the amount of principal you have paid to date represents the percentage of your home that you actually own (your equity).

You have probably noticed that your early payments are mostly interest, with relatively little principal. How could this be?

Is this some sort of scheme to delay your equity or make more money for the banks? Should you call the FBI, SEC, IRS and any other three-letter acronym you can think of? No. It is simply a product of equal regular monthly payments and interest calculations.

The interest charge is based on the amount of money you borrowed (the principal), while your monthly payments are based on both interest and principal. Usually the loan is set up with equal monthly payments to provide consistent predictable expenses.

As you pay your monthly payments, you owe less and less on the principal with each month, so the amount of interest you owe also decreases each month. To keep the monthly payments the same amount, your principal payments adjust upward to make up the difference.

The easiest way to understand it is to illustrate with an example. To make the math simple, let's assume that you have purchased a $200,000 home with a 30-year fixed rate loan at 4.5% annual interest. Your monthly payments are $1013.37.

For the first monthly payment, you will pay 1/12 of 4.5% annual interest on the total principal. If you multiply $200,000 times 4.5% (0.045), you will get $9000, and 1/12 of that is $750. Subtract $750 from $1013.37, and you get $263.37.

That means your first payment of $1013.37 is composed of $750 in interest and $263.37 in principal. Congratulations! You have $263.37 in equity in your home.

For the second month, the principal you owe is $200,000 – $263.37, or $199,736.63, and the interest you owe is $199,736.63 times 4.5% then divided by 12, or $749.01. Subtract that from $1013.37, and you get $264.36.

That means your second payment of $1013.37 is $749.01 of interest and $264.36 of principal. You now have $263.37 + $264.36, or $527.73 in equity in your home.

That pattern continues through all 360 payments. To give you some idea of the changes over time: after five years (at the beginning of the sixth year), your payment will be $683.68 in interest and $329.69 in principal. After fifteen years, your payment will be $496.75 in interest and $516.62 in principal, and your final payment will be $3.79 in interest and $1009.58 in principal.

The bank figures your monthly interest payments and then distributes the principal payments to fill in the gap to even out your monthly payments. This is a win-win – it allows the banks to make more money in interest, but it keeps your early payments from being huge and unmanageable.

This illustrates why making an extra payment toward principal in the early days of the loan has a huge positive effect. If you want to experiment, you can find amortization schedule calculators online that allow you to test the effects of added payments at different times.

Therefore, while the banks do make more money with this approach, it allows you to be able to afford a large house by keeping your early payments more manageable. There's no need to call the FBI, CIA, IRS, or anybody but your lender.

If you are interested in a personal loan, visit our curated list of top lenders .

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