Amortization, in lending terms, is the gradual reduction of the amount of a loan over time, through equal payments or nearly equal payments. It is used in all types of loans, from short term loans to Canadian mortgages with 30 year amortization periods. It can be used to calculate how much your monthly payments will be on your car loan or mortgage, when you know the amount of the loan, the length of the loan, the amortization period and the interest rate. It can also be used to determine how much money can be loaned, if the interest rate, the length of the loan and the monthly payment you can afford are known.
Every loan will contain interest to be paid. This is the fee for using the lender’s money. If your payments are monthly you will be charged interest by the lender, on a monthly basis, on the unpaid balance of the loan. A portion of your monthly payment will be applied to the interest charged and a portion will be used to reduce the loan.
Reducing the Amortization Period
Making an extra payment to reduce the principal balance can have a great effect on the amount of time it will take to pay off loan, just like missing a payment will cause your loan balance to go up. By reducing the amortization period of your loan you will increase your regular payments which will shorten the time it will take to pay off the loan and will save you money in the long term.
A Real Example
Think of the loan as weight on a scale where the lender charges you a fee based on how much weight is on the scale. You decide to pay the lender the same amount every month. The lender checks the weight, charges his fee, and you give him a little extra to remove some of the weight. On your next payment, he charges you a little less, because a little weight was taken off. Since you are paying him the same amount every month, he charges a little less, and takes a little more weight off each month. By the end of the loan, almost all of your payment will be to remove weight from the scale, and his charge will be less.
For instance, if you have a $100,000 Canadian mortgage with a 25 year amortization period at a 4.49% interest rate, which is compounded semi-annually, your monthly payment for principal and interest will be $552.92 per month during a 5 year term.
During your first year of the loan the lender will charge $4403.43 in interest. Since you will have paid $6635.04 in monthly payments, the remaining $2231.61 of your payments will be applied to your principal. During your second year, $2231.61 has been subtracted from the principle loan balance, bringing it down to $97,768.39. Because the balance is slightly lower, less interest will be charged, and slightly more of the payment will go to the principal.
If you hold the same Canadian mortgage you will have paid $65,874.44 at the end of your 25 year amortization period. However, if you are able to reduce your amortization period to 20 years the total interest paid would be $51,169.82. Ultimately, choosing a lower amortization period would save you $14,704.62.
If you are interested in learning more about amortization, please feel free to contact us today!