Knowing your lingo will help you stay well-informed while going through the loan process. One term you might hear is amortization. Let’s take a minute to break down this word and learn what it means.
Simply put, amortization is a way of paying back a loan. With amortized loans, you must pay back what is owed over time. The payments occur on a set schedule (typically once every month) and are usually for the same amount each time. These equal, regularly-occurring payments are known as “installments,” but can also be simply referred to as “payments.”
If all of this sounds familiar to you so far, it’s likely because many of the common loans you may know of (such as car loans and mortgages) are usually paid back by amortization.
Principal & Interest
With amortized loans, the principal and interest are always paid together. Here’s how it works. Every installment you make is divided into the two parts just mentioned: principal and interest. But don’t worry — you’re not required to do math to find out how much should go toward each of those. Normally, the lender’s computer system automatically figures that out for you whenever a payment is made. It does this by calculating a few factors together, including the loan’s interest rate, the total currently owed on the loan, and how many days have passed since the last payment.
When you first start paying back a new amortized loan, you may notice that most of the installments will be applied to interest. That can be a bit discouraging since you’re probably eager to start paying off the principle balance. Keep your chin up and this in mind: As you continue paying down the loan, the portion of your payments that is applied to principle will get bigger and bigger. Eventually, the majority of your payments will go to principal rather than interest.
Fun Fact
The word amortize is rooted in Latin and Old French. Its literal translation is “to kill off.” So, the next time you make a payment, remember that each installment is “killing off” the loan until you're finally debt free.
