Amortization
The process of spreading out a loan into a series of fixed payments over time, ensuring the principal and interest are fully paid off by a specific date.
Amortization is an accounting and mathematical technique used to periodically lower the book value of a loan or an intangible asset over a set period of time.
For consumers, amortization is most commonly encountered when taking out a mortgage or an auto loan.
How an Amortization Schedule Works
When you take out an amortized loan, your monthly payment remains fixed for the duration of the term. However, the composition of that payment changes drastically over time:
- Early Years: A vast majority of your monthly payment goes toward paying off the interest, with very little going toward the principal balance.
- Later Years: As the principal balance slowly decreases, the interest charged on that balance also decreases. Therefore, in the later years of the loan, the majority of your fixed payment goes toward paying down the principal.
An "Amortization Schedule" is a complete table of periodic loan payments, showing the amount of principal and the amount of interest that comprise each payment until the loan is paid off at the end of its term.
A Polymath Insight: The "Rule of 3" for 5-Year Loans
When my family took out a loan at a 12% interest rate, the number "12%" sounded completely manageable. But after paying it off over a standard 5-year EMI schedule, we realized we had paid close to 33% to 36% of the original principal amount just in interest alone!
Because of how amortization math is heavily front-loaded with interest payments, the stated interest rate is highly deceiving.
My mental model for a standard 5-year loan: Multiply the stated annual interest rate by 3. If a bank offers you a 12% interest rate on a 5-year loan, expect to pay roughly 36% (12 × 3) of your original loan amount in total interest.
If you aren't comfortable paying an extra 36% for whatever you are buying, don't take the loan.