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Specifically, I notice that on a mortgage statement, my payment is "amortized" so that at the beginning of the loan, I am paying almost entirely interest and very little principal.

However, on a credit card balance, it seems interest is only charged on the balance.

Why do amortization schedules work the way they do, and are they typically used for most loans, and why?

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What is Amortization?

An amortization schedule is often used to produce identical payments for the term (repayment period) of a loan, resulting in the principal being paid off and the debt retired at the end of the loan. This is in contrast to an interest only, or balloon loan. These loans require little or no payment against the balance of the loan, requiring the loan to be paid indefinitely if there is no term, or requiring the loan to be entirely paid off from cash or a new loan at the end of the term.

A basic amortization formula can be derived from the compound interest formula: Amortization formula from Wikipedia:  P = A*(1-(1/(1+r))^n)/r

This formula comes from the Wikipedia article on amortization. The basics of the formula are the periodic payment amount, A (your monthly payment), can be determined by the principal loan, P, the rate, r, and the number of payments, n.

Why Amortize?

Lenders lend money to make a profit on the interest. They'd like to get back all the money they lent out. Amortization schedules are popular because the fixed low payments make it easier for borrowers to pay the loan off eventually. They also tend to be very profitable for lenders, especially at the start of the term, because they make a lot of profit on interest, just like the start of your mortgage.

The principal of a mortgage has more meaning than the principal of a revolving debt credit card. The mortgage principal is fixed at the start, and represents the value of the collateral property that is your home. You could consider the amount of principal paid to be the percentage of your home that you actually own (as part of your net worth calculation).

Credit Card Amortization

A credit card has a new balance each month depending on how much you charge and how much you pay off. Principal has less meaning in this case, because there is no collateral to compare against, and the balance will change monthly. In this case, the meaning of the amortization schedule on your credit card is how long it will take you to pay off the balance if you stop charging and pay at the proscribed payment level over the term described. Given the high interest rate on credit cards, you may end up paying twice as much for goods in the long run if you follow your lenders schedule.

Who Amortizes?

Amortizing loans are common for consumer loans, unless a borrower is seeking out the lowest possible monthly payment. Lenders recognize that people will eventually die, and want to be paid off before that happens. Balloon and interest only bonds and loans are more commonly issued by businesses and governments who are (hopefully) investing in capital improvements that will pay off in the long run. Thousands of people and businesses have gone bankrupt in this financial crisis because their interest only loans reached term, and no one was willing to lend them money anymore to replace their existing loan.

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Amortization is the process by which your loan balance decreases over time.

For both mortgages and credit card balances, your interest charges are based on what you owe. The calculation of the balance is a little different, but it still is based on what you owe.

You're observing correctly that most of the first payments on a mortgage are interest. This stands to reason since an amortization schedule (for a fixed-rate mortgage) is constructed on the assumption that you're making your payments equally over the course of the mortgage. Since you owe more at the beginning, you accrue more interest, and a larger fraction of your payment is interest. Near the end, you owe little, and most of your payment, therefore, is principal.

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Both Credit Card and Mortgage work on same principle. The interest is calculated on the remaining balance. As the balance reduces the interest reduces.

The Mortgage schedule is calculated with the assumption that you would be paying a certain amount over a period of years. However if you pay more, then the balance becomes less, and hence the subsequent interest also reduces. This means you would pay the loan faster and also pay less then originaly forecasted.

The other type of loan, typically personal loans / auto loans in older days worked on fixed schedule. This means that you need to pay principal + Pre Determined interest. This is then broken into equal monthly installment. However in such a schedule, even if you pay a lumpsum amount in between, the total amount you need to pay remains same. Only the tenor reduces.

  • So in this context Tenor simply means the amount of time taken to actually pay the loan. Does the "fixed schedule" loan go by another name - or is that how it is typically referred to? How would I know upfront whether I was getting a "fixed schedule" loan vs an amortized loan? – Nathan Sep 10 '10 at 1:14
  • Of late post 2000 with quite a few regulations, Fixed schedules are these days not offered. The best way to look is find the terms, how interest is calculated, is it on reducing balance or on the Original principal. – Dheer Sep 10 '10 at 16:27
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Simply put, for a mortgage, interest is charged only on the balance as well. Think of it this way - on a $100K 6% loan, on day one, 1/2% is $500, and the payment is just under $600, so barely $100 goes to principal. But the last payment of $600 is nearly all principal. By the way, you are welcome to make extra principal payments along with the payment due each month. An extra $244 in this example, paid each and every month, will drop the term to just 15 years. Think about that, 40% higher payment, all attacking the principal, and you cut the term by 1/2 the time.

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