Amortization is the gradual reduction of a debt by regular scheduled payments of interest and principal.
Amortization is the gradual reduction of a debt by regular scheduled payments of interest and principal.
Each month, borrowers owe lenders the interest that accrues based on their interest rate and loan balance. When borrowers make their regular monthly payments, the interest is paid first, and the rest of the payment reduces the principal (the loan balance).
For example, a $200,000 mortgage with a five percent interest rate accrues $833.33 in interest expense in its first month. Its mortgage payment is $1,073.64, so that means $240.31 will be applied to the principal balance.
The following month, the loan balance is $199,759.69, so the interest is less — $832.33. That means $241.31 is applied to the principal.
Over time, the amount needed for interest decreases, and more of each payment is available to pay down the principal – until the loan balance is zero.