What Is Amortization?
Amortization is the recovery of financial capital over time. The concept can apply to lending or capital investment.
Amortization In Lending
In lending, amortization is the repayment of a loan through periodic payments. The amount of money borrowed is known as principal. Interest is the cost of using or borrowing this money. In an amortized loan, the payment consists of both principal and interest which vary in proportion over the life of the loan.
Amortization In Capital Investment
Amortization can also refer to the recovery of a capital investment or asset over a period of time. In this sense, amortization helps understand the profitability or productivity of an asset from an investment and finance perspective.
How Does Amortization Work?
In a simple fully amortized mortgage, the loan will be fully paid off over a given period of time. The borrow will typically make fixed monthly payments of the same amount to the lender until the loan is completely paid off.
Initially, the monthly payments will consist mostly of interest, while a small proportion of the monthly payment will reduce the principal, or outstanding amount borrowed. This makes sense, since in the beginning the amount borrowed is very large, so the interest will be larger.
As payments are made on the loan, the outstanding amount borrowed will decrease. This means the basis for calculating the interest decreases. The result is the portion of the fixed monthly payment that goes to pay off the principal increases. Consequently, the portion of the fixed monthly payment that represents interest decreases.
Not all loans are fully amortized. Loans may be made where there remains outstanding principal payable at the end of the loan term in the form of a baloon payment.