Amortization is a method of retiring a debt through consistent, periodic payments of equal amounts for a set period of time. These payments are called amortization schedule payments. Amortization schedules show exactly how much principal and interest is credited with each loan payment, as well as the total amount of interest paid over the life of the loan.
Amortized loans are most often associated with mortgages or automobile loans which have a set principal amount and final payment date. Credit cards do not use amortization schedule payments because they are not loans for a specific amount, and they may remain open indefinitely. These are classified as revolving debt because the customer is allowed to use his card at any time, thereby changing the principal amount, as long as he is under his credit limit and current on his payments.
When a consumer purchases a property using a mortgage, he can ask the lender for an amortization schedule showing the breakdown of each payment. Amortization calculators are also available online, or a schedule can be created manually. Amortization schedule payments are calculated separately, since the amount of interest charged is based on the principal balance for that payment period. For example, the first payment of a $100,000 US Dollar (USD) mortgage would calculate interest based on the full amount borrowed. The amount of principal paid is then deducted from the original loan amount, and the interest for the next payment is based upon the remaining balance.
Amortization schedules are also a good tool to use is comparing the differences between loan payment periods. A 30-year mortgage is very common, primarily because it offers a lower monthly payment for the buyer. A longer mortgage may also be a good choice for a person who only plans to only stay in the property for a short time, and is subsequently not interested in paying off the loan. The reason for this is that it takes 256 amortization schedule payments, or 21 years, to pay off one-half of the principal on a 30-year loan. If the buyer does intend to stay in the property for a long period of time, this is a much more expensive option than a shorter-term note.
Fifteen year mortgages have higher monthly amortization schedule payments because they include a larger amount of principal, but the result is a substantially lower cost over the life of a loan. For example, the principal and interest (P & I) payment on a $100,000 USD loan at 6.5% interest is $632.07 USD, while the P & I payment for a 15 year note for the same amount at the same rate is $871.11 USD. At the end of the 30 year term, the buyer will have paid $227,541.60 USD, which includes $127,541.60 USD interest. At the end of a fifteen year note, the buyer will have paid $156,798.00 USD including $56,798.00 USD interest. The difference between the two is $70,743.60 USD.
Using amortization schedules can also help a buyer determine if it is beneficial for him to pay points, or prepaid interest, in order to get a lower interest rate. He can look up the amortization schedule payments for both interest rates, calculate the difference between the two, and divide that into the amount he will pay for points. The answer will tell him how many months it will take to recover the prepaid interest and begin to see a benefit from the lower rate.