You can define the term easily if you have a solid education in
the basics of finance. You probably know what it is if you've bought a house once
or twice. Or maybe you know sorta, kinda what "amortization" means,
but not really. You wouldn't bet the farm that you completely understand the word.
an explanation, let's turn to experts who promise not to bore you to tears.
up, we have Philip Russel, assistant professor of finance at Philadelphia University,
who defines amortization as "the systemic payment plan -- such as a monthly
payment -- so that your loan is paid off over the specified loan period."
an amortized loan is for one specific amount that is to be paid off by a certain
date, usually in equal monthly installments. Your car loan and home loan fit that
definition. Your credit card account doesn't because it's a revolving loan with
no fixed payoff date.
That's only part of what lenders mean
when they talk about amortization.
Chris Edwards, manager of
the business-to-consumer Web site for IndyMac Bank Home Lending, a mortgage lender,
points out that "amortization" arises from a Latin term that means "to
deaden," and that a common dictionary definition includes the phrase "gradual
"This term sounds about as fun as
a 'pre-need' funeral service sales presentation," he e-mails.
the way, the word "mortgage" has the same Latin root, and literally
means "dead pledge." The property is "dead" to the borrower
if he defaults on the debt, and the pledge is "dead" to the lender after
the loan is repaid. That's how people coined words in the 14th century.)
is less about death than about shrinkage (or "gradual extinguishment").
"A part of the payment goes toward the interest cost
and the remainder of the payment goes toward the principal amount -- the amount
borrowed," Russel says. Interest is computed on the current amount owed "and
thus will become progressively smaller as the ending balance of the loan reduces."
Back to Edwards: "If you've ever had a
mortgage, you'll know that you seem to pay a lot toward interest and not much
toward the principal balance for the first several years of your loan," he
says. "This isn't a complex financial scheme dreamed up by gray-suited bankers
in an underground conference room, but rather simple mathematics."
a mortgage loan for $100,000 at 6.5 percent for 30 years. The monthly principal
and interest payment is $632.07. For the first month, you owe interest for $100,000,
which equals $541.67. The remainder of the payment, $90.40, goes toward principal.
In other words, your debt is reduced by $90.40.
month, you only owe interest on $99,909.60, so $541.18 goes to interest and $90.89
goes to principal," Edwards says. "Month after month, your interest
portion will decrease a bit and your principal reduction will increase. This process
continues until your 360th payment contributes $3.41 to interest and $628.66 to
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