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Amortization Made Easy
Amortization is a difficult to spell and difficult to understand word. It is often misspelled and there are many different ways the word is commonly misspelled. I have often seen the word amortization spelled as amorazation, amortzation, amerazation and amorozation.
The concept of amortization can also be difficult to understand, but really, it is not difficult at all. Amortization is simply the progress a loan makes as it is being paid off. Amortization starts at the full amount of a loan and ends up at a zero balance.
A Payment Has Two Parts
Each payment of a mortgage or a loan contains of two different parts. One part of each payment is the interest paid and the second part is the principal of the balance that is being paid off.
Zero Percent Loans
For example, let's take the case of a type of a loan which really doesn't exist; a zero interest loan. With a zero interest loan, naturally, you would not be paying any interest so there would only be one part of a loan payment. This is because each payment would contain 100 percent principal. So, if you took a loan for $1,000 to be paid over ten months, your payment would be $100 per month.
Interest Only Loans
More commonly than a zero percent interest loan is an interest only loan. With an interest only loan, no principal is ever being paid off. Therefore, there's no such thing as an interest only amortization table. This is simply because an interest only loan never gets paid. In other words it doesn't amortize.
With an interest only loan, only interest is paid with each payment. Therefore an interest only loan is the opposite of a zero percent interest loan. Knowing about zero percent loans and interest only loans makes it easy to see that with a higher percentage loan a larger portion of the payment goes toward interest. Also, with a lower interest rate loan a higher percentage of the payment goes going toward principal.
Another important thing to realize about amortization is that during the early part of the loan, even if the interest is low, the percentage of the payments that go toward principal is very low. It would be typical to see $1,000 going toward interest on the first few payments of a mortgage, while maybe only $70 to $80 would be going toward the principal.
Pay a Little, Save as Lot
Why knowing this is important is because paying double the principal would increase your payment by a small amount but would knock one whole payment off of the term of the loan. For instance, in the example above, paying an extra $70 to $80 would save you $1,000 in interest charges.
Become familiar with how amortization works is very helpful when choosing what loan you're going to get and also with helping to make a payment plan that will save you a lot of money by making relatively small, additional payments.