An amortization schedule is a table designed to keep track of periodic payments for amortizing loans. It summarizes how much is paid each period. This payment is divided between paying off the principal and paying interest on the loan.
Usually, the debtor pays a fixed amount every period until the loan is paid off. This payment is split between paying for the principal amount (the size of the loan arrangement) and paying interest on the loan.
Naturally, during the first payments, a large portion of the periodical payments would be dedicated to interest. That’s because the principal amount is initially large.
Progressively with each period, the amount paid as interest would decrease, and the amount paid for the principal would increase until the principal is paid off completely.
These schedules are essential for businesses and people who want to estimate their costs and expenses throughout the life of the loan. It also lets them find out how much money paid for interest can be saved if they decide to pay more in the future.
Setting an amortization schedule can be done quickly by using an amortization calculator. However, it can also be set up by manual calculations. Therefore, it is helpful to be familiar with how the numbers are calculated, as it will help you to understand the foundations of taking out a loan.
There are several main types of amortization schedules. Each variety uses a different method to amortize a loan. The main techniques are:
Amortizing a loan is a way to repay a debt by periodic - although not necessarily equal - payments. This method requires you to pay interest and a portion of the principal with each regular price.
The principal of a loan is the initial size of the loan that was arranged. It is also called the face value of a loan, used mainly in notating bonds. With the last loan payment, the principal amount of the loan must be fully paid off.
The interest, on the other hand, is the sum of money gradually paid for the service of borrowing the principal. The interest payment is dependent on the interest rate.
The higher the interest rate, the higher the amount of interest paid. Interest rates are usually quoted as annual rates.
As mentioned, the amount of interest paid each period will decrease. That is because paying the appeal is based on the amount of top left.
By gradually paying off the principal, the size of the principal left to pay will decrease. Hence, interest payments will generally decrease over the life of the loan.
It is important to note that the first payment is made at the end of the first period of the loan unless stated otherwise. The size of the last amount, which ultimately repays the debt, can slightly differ from the earlier payments.
The amortization of a debt is completed when the entire principal is paid off. This can include different types of debt and debt instruments, including:
The detailed forecast of costs and expenses throughout the life of the loan is an essential aspect of these types of debt. They accurately list the amount of principal to be paid, the interest expense for that period, and the total outstanding balance that needs to be paid.
As mentioned, amortization schedules are helpful as they include a detailed description of the loan repayment. Such tables usually have multiple rows and columns representing the different variables and parameters.
Usually, the rows of the scheduled show for which period the payments presented belong. Periods are typically quoted in months. The number of rows in the table depends on how many periods are allocated to pay off the debt.
Meanwhile, the different columns in the table summarize the other balances and payments to be made.
The columns usually include:
The interest expense is calculated by multiplying the beginning balance by the annual interest rate. For example, if the loan is amortized monthly, the annual interest rate must be divided by 12 to calculate the interest expense.
The interest expense and the principal paid in a specific period together make up the total payment in a single period.
Below is a schedule that includes all the necessary elements of amortizing a loan.
In this simplified schedule, we can first see that the payments are made annually. Then, looking at the principal paid column, an equal amount of principal is born yearly.
Since the initial principal amounts to $5,000 over five years (which means that $5,000 is being borrowed), the borrower must pay 5,000/5 = 1,000 dollars every year, in addition to interest.
As mentioned, the interest paid is found by multiplying the beginning balance by the interest rate. Supposing the interest rate is fixed at 9%, the interest expense of the first period (the first year) should be equal to $5,000 * 9% = $450.
Notice that the size of the yearly interest expense is decreasing. That is because part of the principal is being paid off with time; hence, interest paid each year will be less than the previous one.
Once we find out the principal payment and the interest expense for a certain period, adding both figures will give us the total payment for the loan.
For example, in year 1, the payment for the principal is 1,000 (as with every year), and interest expense is equal to $450. Therefore, in a year, the total payment for the loan amounts to: 1,000 + 450 = $1,450.
Because payments for the principal are uniform throughout the life of the loan, and interest payments are decreasing with every year, the annual revenues of this specific loan will decrease every year.
This is a crucial characteristic of the amortization method called the straight-line method. Repaying equal amounts of the principal will decrease yearly payments over time. The upcoming sections will discuss other methods of preparing such schedules.
Another important aspect of loan amortization schedules is that the ending balance of one period is the beginning balance of the following period, as seen in every period in the table above.
This is why such schedules are essential for budgeting and organizing loan payments. Using this table, any borrower would quickly know how much they still owe, how high the following cost is, and what percentage of that payment is in the form of interest.
Anyone can easily prepare these schedules with software like Microsoft Excel.