Anyone who has ever had a loan has seen the statements that come updating you on your progress. Early on, it is often disheartening to see that the bulk of your payment went to just the interest, and a small amount went to the outstanding loan balance. If you ever wondered why and how it works, read on. If not, read on anyway, you could still learn something.
When someone gets a new loan, there are several important factors that determine the amortization schedule, or schedule of payments including interest and principal reduction. Those inputs are: loan length in years, number of payments per year, interest rate, beginning balance, and ending balance. In most cases, the ending balance is zero and 12 payments are made per year. Based on these factors, a loan amortization schedule can be created.
There are two ways to create a loan amortization schedule. First is the nerdy finance academic way, which sucks. I promise, I have done it before. It is a stupid waste of time. The second is with a computer, that way takes about five seconds.
Based on the inputs above, the loan amortization calculator will determine what monthly payment is needed for the loan to have the desired ending balance given the interest rate, starting balance, and terms of the loan. The loan is broken up in such a way that you can see what interest is required and what principal balance remaining would be after each period. An easy calculator that gives an annual amortization can be found here. This is a sample amortization for a 30 year fixed mortgage on a $250,000 house at 6%. Notice that in the first year, only $500 goes to the principal, while the rest goes to interest. Because interest only accrues on outstanding principal, interest decreases every year.
Now is the good part. If you pay extra into the loan in a period, that extra amount directly reduces the principal. All of those times I have written about the benefits of early payments can be clearly seen when using an amortization schedule. Fortunately, Microsoft Excel has a great loan template that allows you to include extra payments.
If you understand how loan amortization works, you understand about 90% of important financial concepts. Bonds, loans, and anything with an interest rate uses the same set of formulas to calculate present and future values. Did I confuse you? Feel free to ask questions in the comments.