Loan Amortization Explained: How Every Payment Breaks Down
Loan amortization is the process of paying off debt through fixed payments. Understanding it gives you control over the true cost of any loan. Loan amortization is the process of paying off a debt through fixed periodic payments that cover both interest and principal. When I took out my first car loan, I did not understand amortization. I just saw a monthly payment and a total interest number. After building my own amortization calculator, I understood exactly where every dollar went and how to minimize interest. Here is how amortization works, step by step. The Payment Calculation The first step is calculating the fixed payment that retires the loan over the term. The formula combines the principal, the periodic interest rate, and the number of payments. M = P * r * (1+r)^n / ((1+r)^n - 1) P = principal r = periodic interest rate n = number of payments For a 25,000 car loan at 6 percent annual interest for 5 years, the monthly rate r is 0.06 divided by 12, which is 0.005. The number of payments n is 60. Plugging in, the monthly payment is about 483.32 dollars. This payment stays constant for all 60 months. How Each Payment Splits Each payment is divided between interest and principal. The interest portion is the remaining balance times the monthly rate. The principal portion is the payment minus the interest portion.