Amortization simply involves paying off debt with equal payments at equal intervals over time. An example of this is a fixed rate mortgage – your monthly payment remains the same throughout the entire life of your loan. Even though your monthly payments might look the same at face value ($500 a month let’s say), it’s important to understand how to break down each payment into two components – interest and principal. Each time you make a monthly mortgage payment, part goes towards paying off the interest on your loan, while the rest goes towards the principal (or the remaining amount you owe on your loan). At first, a significant portion of each of your mortgage payments goes towards paying interest, while a small percentage covers the principal.
Over time, the amount you pay in interest each month slowly decreases, while the amount that goes towards the principal slowly increases. By the time you reach your last payment, it will be made up of entirely principal – and you’ll have paid off you loan! Now, you’re probably thinking – “That’s nice, but why does this matter?”
When making decisions about amortized loans (home and car loans are common), many people make the mistake of looking at only the cost of each monthly payment. While this is an important factor, looking at only the total monthly payment means you aren’t able to see how much you’re paying in interest vs. paying down your principal. To uncover this information, it’s smart to create an amortization table that outlines how much you’re spending and where. That way, you can see easily and transparently, the actual cost of your loan. You may, for example, be getting a lower monthly payment, but be paying for your loan over a longer period of time, meaning you are paying more in interest than if you went with a higher monthly payment from day one.
