What is an amortization schedule and how does it work?

An amortization schedule is a detailed table or chart that shows the breakdown of each periodic payment on a loan, such as a mortgage or car loan. It provides a clear picture of how each payment is allocated between paying off the loan principal and covering the interest charges. Here's how it works:

1. Loan Amount: The amortization schedule starts with the original loan amount, which is the total amount borrowed.

2. Interest Rate: It includes the interest rate associated with the loan. This rate determines how much interest you'll pay on the outstanding balance.

3. Loan Term: The schedule specifies the loan term, which is the number of months or years over which you'll repay the loan. For example, a 30year mortgage has a loan term of 360 months.

4. Monthly Payment: It calculates the monthly payment you need to make to repay the loan within the specified term. This payment includes both principal and interest.

5. Principal Payment: Each month, a portion of your payment goes toward repaying the loan's principal amount. As you make payments, the principal balance decreases.

6. Interest Payment: The remaining part of your monthly payment covers the interest charges. Early in the loan term, a significant portion of the payment goes toward interest, but this gradually decreases over time.

7. Total Payment: The schedule shows the total monthly payment, which is the sum of the principal and interest payments.

8. Outstanding Balance: After each payment is made, the schedule displays the remaining outstanding balance on the loan. This balance decreases with each payment.

9. Cumulative Payments: The schedule also calculates the total amount you've paid over the life of the loan. This includes both principal and interest.

10. Equity Buildup: Over time, as you make payments, the portion going toward principal increases. This leads to equity buildup in the asset, such as a house, as you gradually own more of it outright.

Amortization schedules are valuable tools for borrowers because they provide transparency into how loans work and help you understand how much interest you'll pay over the life of the loan. They are especially useful for mortgages, as they allow borrowers to see how extra payments or additional principal payments can accelerate the repayment process and save on interest costs.

You can use online calculators or spreadsheet software to generate an amortization schedule for your specific loan, which can help you plan your finances and make informed decisions about your loan payments.