Amortization is a financial term used primarily in the context of loans, particularly for mortgages. It refers to the process of paying off a debt over time through regular payments, which typically include both principal and interest.


Here’s a more detailed explanation of how amortization works:

Principal: The principal amount of a loan is the original sum of money borrowed. For example, if you take out a $200,000 mortgage to buy a house, $200,000 is the principal amount.

Interest: Interest is the cost of borrowing money, expressed as a percentage of the loan amount. Lenders charge interest to compensate for the risk of lending money and to make a profit. The interest rate is typically stated as an annual percentage rate (APR). In the case of the mortgage, you’ll pay interest on the outstanding balance of the loan.

Amortization Schedule: An amortization schedule is a table that outlines each payment on a loan, breaking down how much of each payment goes towards paying off the principal and how much goes towards paying the interest. At the beginning of the loan term, a larger portion of the payment goes toward paying off the interest, while a smaller portion is applied to the principal. Over time, as the loan is paid down, the portion of the payment applied to the principal increases while the portion applied to interest decreases.

Regular Payments: Borrowers make regular, fixed payments according to the amortization schedule, typically on a monthly basis for mortgages. Each payment goes towards reducing the outstanding balance of the loan.

Decreasing Balance: As payments are made, the outstanding balance of the loan decreases. This reduces the amount of interest charged on the remaining balance over time.

End of Amortization: The loan is fully amortized when the outstanding balance reaches zero, meaning that the borrower has paid off the entire loan amount, including both principal and interest.

Amortization is important for borrowers to understand because it helps them determine how much of each payment goes towards reducing the loan balance and how much is being paid in interest. It also allows borrowers to see how long it will take to pay off the loan completely based on their payment schedule.

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