What Is Amortization? Definition And How To Calculate It

The financial side of buying a home can sometimes be confusing. Sure, you probably understand the basics of a mortgage – borrow money from a bank to get a house – but as you get into the weeds in this process it can get pretty complicated.

Your lender will explain the loan amount you qualify for, interest rates, mortgage insurance and other factors that make up your monthly house payment. If that amount is something you can comfortably handle financially and you have found the home you want, you might stop thinking about it there.

However, understanding exactly how your mortgage payment is constructed is a good idea. The more you understand about how your loan is set up and how it changes over time, the more secure you’ll feel in the financial commitment you’ve made.

A big part of this is understanding mortgage amortization, a term you have or will hear about during the loan approval process. They will also likely mention an amortization schedule, which will help you understand the nature of your mortgage now and over the life of the loan. So, what is amortization?

What Does Amortization Mean?

There are two main definitions of amortization. One relates to loans (like a mortgage) and the other to the depreciation of an intangible asset. When you pay your home mortgage over time through monthly installments, you are paying both the interest and the principal. You pay different amounts to each depending on the date of each payment, but by the end of the loan term you have paid off both the interest and the principal. This is amortization.

The other definition of amortization – related to the depreciation of an intangible asset - is used for tax and accounting purposes. The expenses related to the asset are spread out over the course of the asset’s useful life, which is a form of amortization. For this article, we will focus on amortization related to loans.

What Is Loan Amortization?

Let’s take a look at how amortization works on a personal loan as an example. Many Americans take out personal loans for a variety of reasons. Common uses include debt consolidation, home improvements, education, starting a business and covering large unexpected medical expenses. Personal loans must be paid back, of course, including any interest. Amortization refers to the amounts you pay back each month (as well as the total term of the loan) for both the principal amount of the loan and the interest being charged for borrowing.

What Is Mortgage Amortization?

Amortization works the same way on a mortgage compared to a personal loan. That said, there are some differences regarding how mortgage amortization works depending on whether you have a fixed-rate or adjustable-rate mortgage.

If your rate is fixed for the entire term of the loan, creating an amortization schedule for the entire loan is relatively simple (more on that below). If you have an adjustable rate mortgage, the amortization schedule will need to be, you guessed it, adjusted as the interest rate fluctuates.

What Is An Amortization Schedule?

An amortization schedule outlines the components and amounts of each loan payment throughout the course of the loan. There are usually six components of a loan amortization schedule:

1. The term of the loan
2. Beginning loan balance
3. Payment
4. Interest
5. Principal
6. Ending loan balance

Keep in mind that the type of loan can impact the breakdown of the amortization schedule, so check with your lender on the schedule for your specific mortgage or other type of loan.

How To Calculate Amortization

Ok, let’s dive into how to calculate amortization. You can find more than a few online calculators and spreadsheet templates as alternatives to using a formula to calculate amortization manually, but understanding the formula first is a good knowledge base to start with. 

Calculating amortization starts with the following variables:

• Loan amount: This is the initial amount of money you are borrowing, not including interest.
• Loan term: This refers to the amount of time you have to pay off the loan, including interest.
• Interest rate: This is the amount you pay to borrow the money, which is represented in a percentage of the loan amount. This is sometimes also represented as an annual percentage rate (APR).

To calculate the amortization on a loan, take the loan amount and multiply it by the interest rate. Next, calculate your monthly interest by dividing the result by 12. Take the total monthly payment and subtract the monthly interest to calculate the amount that will go toward the principal. This covers the first month’s payment. To calculate the next month, subtract the amount you paid in the first month toward the principle and repeat the calculation again. Continue these steps month by month for the entire term of the loan to get the full amortization schedule for your loan.

Loan Amortization FAQs

Hopefully you now have a pretty good understanding of the definition of amortization and how to calculate it. However, some questions may remain. Let’s look at some frequently asked questions regarding amortization.

What is an amortized loan?

An amortized loan is a loan that has a set term where periodic payments (usually monthly) are made toward both the principal and interest of the loan.

What is negative amortization?

Negative amortization is a term used to describe a loan where the total loan amount increases each month even when you pay the minimum payment on time. This happens when the amount of each payment is less than the interest due on the loan. Beware of this, as it can create a serious financial hole.

What is accelerated amortization?

Accelerated amortization is when you pay more than your monthly minimum payment toward the loan to reduce the overall interest you will pay over the course of the loan. For example, this can sometimes be achieved with biweekly mortgage payments.

What is the difference between depreciation and amortization?

Amortization spreads the cost of something over the course of its useful life. Depreciation, in contrast, is calculating the expense of something to reflect its anticipated deterioration over time.

Does refinancing reset an amortization schedule?

If you are looking to refinance, be sure to note that your amortization schedule will likely reset. The exception to this is if you refinance for a shorter loan term.

The Bottom Line

Understanding amortization is a great way to look into your financial future when it comes to your monthly loan payments. Looking for some help? The Rocket Money^SM app can provide you with one place to track all your monthly payments. Consider downloading the Rocket Money app for help with keeping track of your due dates for loan payments and all your other bills.