Financial Planning
October 13, 2021

How to calculate loan amortization?

Loan amortization is the process of paying off a loan following an agreed-to schedule.

"Amortization" sounds complex, but it describes the way you probably already think about loans. It's an awkward-sounding word that refers to making loan payments according to scheduled installments.

What are amortized loans?

Most personal loans, auto loans, and home loans are amortizing loans. When you take out one of these loans, you usually specify a flat monthly payment. Throughout the life of the loan, your monthly payment will apply to both the principal and interest due on the loan, at shifting percentages, following a payment calendar usually stipulated by monthly payment periods.

Beyond that, amortized loans can vary widely, with different payment amounts and repayment schedules depending on many variables, from the interest rate and the loan term to your lender's requirements.

For example, a 30-year mortgage and a 2-year personal loan can both be amortized, but the mortgage loan is likely to have more components, with different requirements for down payments, first payments, and even special carve-outs for extra payments.

With mortgages and auto loans, a high percentage of your initial payments often goes toward paying off interest on the loan. With each subsequent payment, more and more of your monthly payment goes toward the loan's principal.

An amortization schedule reveals how much of each monthly payment goes to paying interest - showing you how much your loan is costing you over its full payment schedule.

How do you calculate loan amortization?

To calculate loan amortization, follow these steps:

Step 1: Determine the monthly interest payment by multiplying the outstanding loan balance by the monthly interest rate.

Step 2: Calculate the principal payment using calculators like the Bright Loan Repayment Calculator by subtracting the interest payment from the total monthly payment.

Step 3: Update the outstanding balance by subtracting the principal payment from the previous balance.

Step 4: Repeat the process until the loan is paid off.

How to build a loan amortization schedule?

Amortization calculators can be found across the internet. Most lenders offer financial calculators with online amortization charts. Spreadsheet software, like Microsoft Excel, often has amortization built in too.

But here's how you can create your own amortization schedule, calculating the balance of interest and principle in each monthly payment.

It takes a little math. But making your own loan amortization calculator is a good reminder of how much your loan costs you month by month.

Step 1: Start by calculating your monthly interest payment. Multiply the loan's interest rate by the outstanding loan balance, then divide by twelve. This changes, of course, as you pay off more and more of the loan.

Step 2: Then calculate the amount of principal due. Take your flat monthly payment and subtract the month's interest payment. The remaining balance is the payment against your principal.

Step 3:The next month, subtract your most recent principal amount from the outstanding balance. The result is your new outstanding balance. Use that new balance to calculate your interest payment again. When you subtract your interest payment from your flat monthly payment, you'll have your new principal payment.

Step 4: Repeat the same math month after month until your loan balance is zero at the end of the loan term.

How to calculate principal payments?

Here's a loan amortization calculator formula for calculating your monthly principal payment:

Principal payment = total monthly payment – (outstanding loan balance * (interest rate / 12 months))

However, if you're trying to estimate monthly payments based on given factors, such as the loan amount or the interest rate, you may need to calculate the monthly payment too. Here's a formula for calculating the total monthly payment:

The formula for calculating the total monthly payment on a loan is:

Total monthly payment = loan amount * [i * (1 + i) ^ n / ((1 + i) ^ n - 1)]

Where:

• i = monthly interest rate. To find this, divide your annual interest rate by 12. For instance, if your annual interest rate is 3%, your monthly interest rate would be 0.0025 (3% annual interest rate / 12 months).
• n = number of payments over the loan’s lifetime. To determine this, multiply the number of years in your loan term by 12. For example, a 4-year car loan would entail 48 payments (4 years * 12 months).

Steps to calculate loan amortization

Let's look at an example

Let's look at a four-year, \$40,000 personal loan at 3% interest. The monthly payment is going to be \$664.03 (\$30,000 ((.0025 (1.0025 ^ 48) / (1.0025 ^ 48) - 1))).

In the first month, \$75.00 of the \$664.03 monthly payment goes to interest (\$30,000 outstanding loan balance * 3% interest rate / 12 months) while the remaining \$589.03 goes toward principal (\$664.03 total monthly payment - \$75.00 interest payment).

Each month, the total payment stays the same, while the portion of the payment going to principal increases and the portion going to interest decreases. In the final month, only \$1.66 is paid in interest because the outstanding loan balance at that point is so small.

What's the difference between amortization and depreciation?

Amortization and depreciation are almost the same, except in specific accounting concerns. Both look at the cost of holding an asset, including the cost of paying off a loan over time. However, amortization can include intangible assets, like intellectual property, patents and trademarks, while depreciation considers only tangible assets, like equipment and buildings - things that can show physical wear and tear.

Conclusion

In summary, amortization is a common concept in loans, where monthly payments cover both the principal and interest over the loan term. This method applies to various loans, including personal loans, auto loans, and mortgages, providing borrowers with a structured repayment plan. Creating an amortization schedule allows borrowers to understand how each payment contributes to paying off the loan and reducing the outstanding balance over time. While calculators and spreadsheet software can help generate amortization schedules, understanding the underlying calculations empowers borrowers to make informed financial decisions and track their loan progress accurately.

Why Bright Money?

Bright Money offers a suite of innovative financial products designed to assist individuals in rebuilding their credit and achieving financial wellness. Bright Plan is at the forefront of these offerings, a comprehensive financial planning tool that empowers users to create personalized budgets, track spending habits, and set achievable financial goals. Bright Plan helps users make informed decisions to improve their credit standing by providing actionable insights and recommendations based on individual financial circumstances.

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In addition to Bright Plan and Bright Builder, Bright Money offers Bright Credit, an innovative tool designed to further enhance users' credit-building efforts. Bright Credit provides personalized strategies and insights to help users optimize their credit utilization, manage credit inquiries, and strategically improve their credit score over time. With Bright Credit, users can take proactive steps towards achieving their financial goals and securing a brighter financial future.

Why Bright Money?

Bright Money offers a suite of innovative financial products designed to assist individuals in rebuilding their credit and achieving financial wellness. Bright Plan is at the forefront of these offerings, a comprehensive financial planning tool that empowers users to create personalized budgets, track spending habits, and set achievable financial goals. Bright Plan helps users make informed decisions to improve their credit standing by providing actionable insights and recommendations based on individual financial circumstances.

Bright Builder, another flagship product, is specifically tailored to help users establish and build their credit history. Through responsible use of Bright Builder, individuals can gradually build positive credit activity, leading to improved credit scores over time. Moreover, Bright Money offers educational resources and personalized coaching to support users' credit-building journey. By combining cutting-edge technology with expert guidance, Bright Money provides a holistic approach to financial wellness, empowering individuals to take control of their finances and build a brighter future.

In addition to Bright Plan and Bright Builder, Bright Money offers Bright Credit, an innovative tool designed to further enhance users' credit-building efforts. Bright Credit provides personalized strategies and insights to help users optimize their credit utilization, manage credit inquiries, and strategically improve their credit score over time. With Bright Credit, users can take proactive steps towards achieving their financial goals and securing a brighter financial future.

FAQs

1. How do I build a loan amortization schedule?

You can create a loan amortization schedule using online calculators, financial software, or by performing the calculations manually. To calculate each month's payment, you'll need to determine the monthly interest payment and subtract it from the total monthly payment to find the principal payment. Then, adjust the outstanding balance accordingly for the next month's calculation until the loan term ends.

2. What is the difference between amortization and depreciation?

Amortization and depreciation both involve spreading out the cost of an asset over time, but they apply to different types of assets. Amortization typically refers to intangible assets like patents and trademarks, while depreciation is used for tangible assets like equipment and buildings. Both methods account for the gradual reduction in value or the payoff of a loan over time.

3. How are loan amortization payments calculated?

Loan amortization payments are calculated using formulas that consider the loan amount, interest rate, and loan term. The total monthly payment is determined by dividing the loan amount by a factor that includes the monthly interest rate and the number of payments over the loan's lifetime. Each monthly payment covers both the interest and a portion of the principal, gradually reducing the outstanding balance until the loan is paid off.

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References

https://www.fool.com/the-ascent/personal-finance/how-is-loan-amortization-schedule-calculated/