Loan Amortizations

What you need to know

by Kevin Mcinturff

Suppose you are looking towards securing a loan whether it is a commercial, home, auto or free, the debt you incur will need to be paid back over time through periodic payments. This is called "amortizing" the loan or loan amortization. For example, suppose that you just bought a car and you took out a loan for the purchase. A part of each payment you make will cover the interest you owe, along with the principal.

For a better understanding of how this works, here are some definitions:

  • Principal. the initial amount of the debt, usually the price of the item purchased.
  • Interest Rate. the amount one will pay for the use of someone else's money. Usually expressed as a percentage (so that it can be expressed for any period of time).
  • Time. essentially the amount of time that will be taken to pay down (eliminate) the debt. Usually expressed in years, but best understood as the number of and interval of payments, i.e., 36 monthly payments.

For simple interest, the calculation uses the following formula: PMT is a function of N, PV and I/Y, where:

  • PMT = Amount of Monthly Payment
  • N = Number of Payments
  • PV = Present Value or Current Amount of Loan
  • I/Y = Interest Rate

Let us return to the above example: suppose the dealer gives you a price on a car which is $18,000 and tells you that you may make 36 monthly payments using six percent interest (6%) on the loan. How much would your monthly payment be? The facts are:

  • Agreed price of 18,000 for the car, taxes included.
  • 3 years or 36 equal payments to pay off the debt.
  • Interest rate of 6%.

After using the above formula, you monthly payments will be $547.59. It is important to understand that the initial payments will include more interest than principal. Therefore it sometimes helps to pay a little more on each installment to get the principal down more quickly. It is also important to know that the longer the note, the more interest you will pay. Therefore, it will save you more money to use shorter loan periods.

Of course, the above example can be applied to any type of loan such as home or commercial. For businesses, it is good to know that any interest that you pay on loans can be deducted as an expense on your taxes along with the depreciation on any equipment you may have bought with that loan.

So understanding loan amortization is not that complicated. If fact, for a few dollars, you may purchase a financial calculator which will have you calculating loan payments in no time. Just remember that all amortization is just the interaction of the four variables of time, interest, principal and payment.

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