Wondering how monthly loan payments are calculated? Want to know how the principal and interest are distributed over the repayment period? If you are planning to buy a house, or a vehicle, or invest in your business, you have to understand the concept of amortization. Many would say that it is just a financial term, but instead, it is just more than that! Moreover, we would say that it is a practical tool that will help borrowers to repay their loans over time. So we decided to dive deep into the world of amortization and understand what it is and also know how it’s calculated. So let’s begin!

What is Amortization? 

Amortization is referred to as the systematic process of paying off a debt or loan over a set period via regular instalments. All the instalments paid under this have both the principal and interest. Through this, the borrowers reduce their outstanding balance and ensure timely repayment until the debt is fully written off.

The Importance of Amortization

As stated earlier, you have to understand amortization when you think of a loan and its payments. After all, what comes across is managing the finances effectively. It will give you more clarity on the portion of the loan payment that has interest versus the portion that has principal. This also is handy as you can easily find out interest payments on income tax forms. Plus for the companies, they can easily plan to understand what the company’s future debt balance will be after a series of payments have already been made.

How to Calculate Amortization? 

To calculate amortization, we will focus on the common loan repayment structure, which is the fixed instalment method. You can follow the steps outlined below to calculate amortization easily:

Step 1: Gather the necessary information:

• Loan amount: The initial amount borrowed.
• Interest rate: The annual interest rate charged by the lender.
• Loan term: The duration of the loan in months or years.

Step 2: Determine the payment frequency:

You have to know whether the loan is to be repaid in quarterly, monthly, or annual payments. For this instance, we will use monthly payments.

Step 3: Calculate the periodic interest rate:

Next, you have to check out the periodic interest rate. You can easily do this by dividing the annual interest rate by the number of payment periods in a year

Step 5: Calculate the fixed monthly instalment:

Use the formula for calculating the fixed monthly instalment:

• A = P * r * (1 + r) ^n / ((1 + r) ^n – 1) Where:
• A = Fixed monthly instalment
• P = Loan amount
• r = Monthly interest rate
• n = Total number of payment periods

Major Advantages and Disadvantages of Amortization

Amortized loans are the ones where you have to pay a defined amount over time. So in a way, you can better formulate your budget and cash flows over the long term. Such kinds of loans are also beneficial as there is a principal amount in each payment so the outstanding balance of the loan is going to get reduced over time. The major drawback of amortized loans is that initially very little principal is paid off. Out of which most of the payment goes in interest. So in terms of a mortgage, very little equity is getting built in early on which is not helping you at all if you wish to sell a house just after a few years.

Conclusion

So that was our take on Amortization. We hope that by now you would have understood the entire concept of this term. If you can understand the meaning of this concept, you can certainly make well-informed decisions about your loan repayments. And if you have any difficulty in managing your loans or find Amortization challenging, you can contact KPG Taxation which has a team of expert tax accountants who will guide you with it.