What is Loan Amortization?
The Loan Amortization Schedule outlines the interest expense obligation and principal payments owed on a loan, such as a mortgage, including the outstanding balance of the financing.
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How to Calculate Loan Amortization
The loan amortization schedule describes the allocation of interest payments and principal repayment across the maturity of the loan.
The borrower is required to fulfill payment obligations per the schedule laid out in the contractual agreement with the lender as part of the financing arrangement.
In particular, there are two forms of payment associated with loans: 1) the interest expense and 2) the principal amortization.
- Interest Expense ➝ The interest component reflects the cost of the borrowing, i.e. the credit risk associated with providing debt to the borrower is factored into the interest rate by the lender.
- Principal Amortization ➝ The principal payments, on the other hand, represents the gradual repayment of the original principal over the maturity term.
Over the length of the borrowing term, the loan’s book value gradually reduces in value until the outstanding balance reaches zero on the date of maturity.
If the loan principal balance does in fact reach zero, the borrower met its mandatory debt obligations on time and managed to not default, i.e. did not miss an interest or principal payment.
What is Fixed-Rate Amortization Schedule?
The amount of interest owed each period declines in proportion to the amount of principal repaid, despite the fixed interest rate, so the interest owed declines as more of the loan’s principal is recouped by the lender.
While the interest paid each period is in fact a function of the outstanding principal balance, interest payments do NOT reduce the principal.
Therefore, the capital at risk—the money that could be lost in the event of default—is the loan principal itself. The lender is risking losing the original loan under the belief that the borrower can meet the interest requirements and return the principal in full by maturity.
In a fixed-rate amortization schedule, which tends to be the standard among mortgage financing loans, the repayment of the loan is completed in equal installment payments.
The value of the principal and the interest payments, however, will be different between each payment period.
Starting off, a higher proportion of the total payment will go towards servicing interest. But over the course of the borrowing term, the percentage attributable to principal payments increases (and the interest payments decline).
