Amortization

In an amortising loan, every payment is the same size, but what it pays for changes over time. Early payments are mostly interest, because interest is charged on a large balance. As the balance shrinks, less of each payment goes to interest and more goes to reducing the principal.

Take a 200,000 mortgage at 6% over 25 years. The monthly payment is about 1,289. In the first month, interest is 1,000, because 6% a year is 0.5% a month on 200,000, so only about 289 reduces the balance. Near the end of the loan, almost the entire payment goes to principal.

A table showing each payment split into interest and principal, along with the remaining balance, is called an amortization schedule. It is useful for seeing how much of the debt has really been repaid at any point.

This pattern explains why extra payments early in a loan are so effective. Money paid towards principal early reduces the balance on which all future interest is charged.

The same word is also used in accounting for spreading the cost of an intangible asset over its useful life. That meaning is covered under Amortization Expense.