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Understanding Loan Amortization
When you take out a standard loan—whether for a car, a personal expense, or a home mortgage—you are usually agreeing to an amortized loan. Amortization is the process of spreading out a loan into a series of fixed payments over time.
While your monthly payment remains exactly the same every single month, the way that payment is applied changes drastically over the life of the loan. In the beginning, a large percentage of your payment goes entirely toward paying the interest. Only a small fraction goes toward paying down the actual money you borrowed (the principal). As time goes on and the principal shrinks, the interest charged shrinks with it, meaning more of your fixed payment starts going toward the principal.
The Amortization Formula
If you were to calculate your fixed monthly payments manually, you would use this standard formula:
M = P[r(1+r)^n] / [(1+r)^n - 1]
- M = Total fixed monthly payment
- P = Principal loan amount
- r = Monthly interest rate (Annual rate divided by 12)
- n = Number of total payments (Total months)
How to Save Money on Your Loan
Because interest is calculated every single month based solely on your current remaining balance, the best way to save money on any loan is to pay down the principal balance as fast as possible.
- Make bi-weekly payments: Instead of paying once a month, pay half your payment every two weeks. Because there are 52 weeks in a year, you will naturally make 26 half-payments (or 13 full payments) a year. This extra payment goes straight to the principal, shaving months off your loan and saving thousands in interest.
- Pay extra towards "Principal Only": If you get a bonus at work or have extra cash, make a manual payment to the lender and specify that the payment is for the "Principal Balance Only." This immediately reduces the burden upon which next month's interest is calculated.
- Refinance: Keep an eye on the national interest rates. If average rates drop 1-2% below what you currently pay, consider refinancing your loan to lock in a cheaper rate.
Types of Standard Loans
| Loan Type | Typical Term | Collateral / Security |
|---|---|---|
| Auto Loan | 36 to 84 months | Secured (The car is collateral) |
| Personal Loan | 12 to 60 months | Unsecured (Based on credit score) |
| Mortgage | 15 or 30 years | Secured (The house is collateral) |