What Is Amortization? - Microsoft 365 (2024)

Microsoft 365 Life Hacks > Budgeting > What Is Amortization? How to Calculate it—and How to Use It

August 06, 2021

If you have loans, you’ve likely been told about amortization. Maybe your loan officer showed you an amortization schedule before you signed your loan documents, columns that listed payment amounts and how each payment would be applied to your loan’s principal and accrued interest. But what is amortization, and why is it important to understand how it works?

What Is Amortization? - Microsoft 365 (1)

Amortization Basics & Types

At its most basic, amortization is paying off a loan over a fixed period of time (the loan term) by making fixed payments that are applied toward both loan principal (the original amount borrowed) and interest (the charge for taking out the loan, a percentage of the principal).

For example, if you are paying a mortgage, car loan, or student loan with a fixed interest rate, your monthly payment will remain the same over the lifetime of your loan, but the amount of each payment that goes toward principal and interest will change. Interest costs will be a higher portion of your monthly payment at the beginning of the loan because it is a percentage of your outstanding principal; as more of your monthly payments are applied to principal, the interest costs shrink.

There is another financial situation in which you might come across amortization: bookkeeping and taxes for a small business or freelance gig, wherein the cost of an asset is spread out across the lifetime of the asset. For now, let’s focus on amortization and amortization schedules as they apply to loan repayment.

What Is Amortization? - Microsoft 365 (2)

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How to Create an Amortization Schedule

To calculate basic amortization and create an amortization schedule, you need the following information:

Original loan amount
Loan disbursem*nt (or start) date
Monthly payment amount
Interest rate (typically annual)
Repayment period (typically in years)

Let’s say you have a car loan of $15,000. Your interest rate is 3%, and the loan term is 5 years. Your minimum monthly payment is $200. What would your amortization schedule look like? Here’s how to start your amortization chart, beginning with the first month:

Multiply the total amount of the loan by the interest rate: 450
Divide that number by 12 to get the first month’s interest charge: $37.50
Subtract the first month’s interest charge from the fixed payment amount to see what portion of the first month’s payment will be applied to the loan’s principal: $162.50
This loan’s first payment would be divided as $37.50 toward interest, $162.50 toward paying down principal.

This process is then repeated, for each following month, with the new outstanding principal total used instead of the original total.

How to Use an Amortization Schedule

Creating your own amortization schedules to understand your loans is a valuable tool for maintaining your financial health. Once you have set up an amortization chart, you can start plugging in different amounts for monthly payments. How much could you save in interest payments over the lifetime of your loan if you pay an extra $10 every month? Paying off your mortgage early can save hundreds or thousands on interest payments—what can you change in your budget to make that happen? Considering refinancing a student loan? Plug in possible interest rates and loan term periods to see if you’ll actually save.

Taking charge of your finances doesn’t necessarily mean creating amortization schedules for each loan you may have, but understanding what amortization is can provide you the tools to plan your current and future finances with more certainty.