Amortization

Financial Dictionary -> Mortgages -> Amortization

The process of liquidating a debt over a period of time is the simple explanation of amortization. For instance, if you have a mortgage on your home, the principal you pay is a predetermined sum that needs to be paid in a certain amount of time. However, interest must be figured in such a way as to make each payment equal the same amount in a fixed time to satisfy, or pay off, the loan. Generally, a loan payment is due once each month. Therefore, if you have a debt of $40,000 that you would like to pay off in 20 years, you would amortize, or completely extinguish, it within that time frame. It would be simple to calculate the payments (40,000 divided by 240 months) if not for the interest that is added. In that case, it may be beneficial to have the help of an amortization calculator.

One such calculator is located at: Financial Calculators This web-based calculator does not just calculate payments; it can also handle negative amortizations, balloon payments and some extra payments. Mostly, amortization is used to figure mortgages, but you may also use this amortization calculator to figure credit card payments as well.

If you figured your $40,000 20-year loan at a rate of 9% interest, your payments would be $359.89 each. By the time you had paid off, or amortized, your loan, you would have paid a total of $86,373.60. However, if you had borrowed the same amount at the same interest rate for a period of 30 years, your payments would have been lower at $321.85, but the total amount you would pay at the end of the fixed time would be higher at $115,866.

Some people prefer negative amortization. However, in negative amortization, while payments are lower, the final payment is much higher as the borrower has to pay the interest he failed to pay initially. It works like this: payments are too low to cover interest costs, so every time a payment is made, what is not covered is added to the final payment. Negative amortization is sometimes used by people who want to buy a house but cannot afford high payments. The theory is that as their income increases over time, they'll be better able to pay the higher final payment at the end of their loan period. While this strategy will keep monthly payments low, it's risky.

When entering into a loan agreement, your best bet is to borrow the least amount of money for the least amount of time. Calculate each loan before you enter into an agreement to get the greatest benefit. Understanding amortization can go a long way to saving rather than spending more of your hard-earned cash.