How Loan Amortization Works
Amortization is how a fixed loan payment pays off both interest and the balance on a set schedule. Once you understand it, an amortization schedule is easy to read and it is clear why extra payments help most early on.
By the Loan Calculator team · Updated
The idea in one paragraph
With an amortizing loan you make the same payment every month. Each month the lender first charges interest on the balance you still owe. Whatever is left of your payment reduces the balance. Because the balance shrinks, next month’s interest is a little lower, so a little more of the same payment goes to principal. This repeats until the balance reaches zero on the final scheduled payment.
A worked example
Take a $20,000 loan at 6% for five years. The monthly rate is 6% ÷ 12 = 0.5%, and the payment works out to $386.66.
Month 1: interest is $20,000 × 0.5% = $100.00, so $286.66 of the payment reduces the balance to $19,713.34.
Month 2: interest is charged on the lower balance — $98.57 — so slightly more, $288.09, goes to principal.
Month 60: only $1.92 is interest and $384.73 is principal. Over the whole loan you pay $3,199.36 in interest.
The payment formula
The fixed payment M that pays off a loan of P over n months at monthly rate r is M = P × r(1 + r)ⁿ ÷ ((1 + r)ⁿ − 1). With a 0% rate, the formula reduces to P ÷ n. Our calculators use this formula, then build the schedule month by month as described above.
Real lenders round each payment to the cent, and the last payment is adjusted to clear any remaining cents. Some loans, including many auto and student loans, accrue interest daily, so the exact split depends on when your payment arrives. These differences are usually small.
Reading an amortization schedule
Each row of a schedule shows one payment. The columns usually include:
- Payment number or date.
- Interest — the balance multiplied by the monthly rate.
- Principal — the payment minus the interest.
- Remaining balance — last month’s balance minus this month’s principal.
Why early payments matter most
Interest is charged on the outstanding balance, so it is highest at the start. On long loans such as 30-year mortgages, most of each early payment is interest. Any extra principal you pay early removes that balance before it can earn interest for the many months left, which is why early extra payments save the most.
Loans that don’t amortize this way
Interest-only loans, balloon loans, credit cards and lines of credit do not follow a fixed amortization schedule. Income-driven student loan plans can also leave the balance growing if payments are less than the interest. Our calculators assume a standard fully amortizing loan.
Try it with your own numbers
Sources and further reading
- Regulation Z (Truth in Lending), 12 CFR Part 1026 — Consumer Financial Protection Bureau
- Mortgages: tools and answers — Consumer Financial Protection Bureau