Loans with predictable terms, like 15- or 30-year mortgages are amortized. This means that you know how much interest you’ll pay by the end of the loan when the loan starts. Because you know this information, and you know how much you borrowed, you know the total cost of the loan: the principal plus the interest. This sum can then easily be divided by the number of pay periods in the loan—360 for a typical mortgage paid once a month every month for 30 years, for instance—to calculate the (fixed) monthly payment.
It’s important to realize, however, that when you’re building equity in something paid for by a loan that has been amortized, in the beginning, you’ll build equity very slowly because the interest has been front-loaded on the loan. In the first pay period, you pay a huge amount of interest and a tiny amount of principal. In the next pay period, you pay slightly less interest and slightly more principal. This spreading out of a known quantity of interest, given the known life of the loan and a known interest rate is "amortization."
One consequence of how this system works is that, over time, the proportion of your payment each period which is interest decreases, and at the same time, the amount of your payment each period which is principal increases. There exists a symmetry in the principal and interest in amortized loans: early on, you pay almost all interest and almost no principal, and at the end, you pay almost all principal and almost no interest.
Remember that only the principal builds equity; the interest is simply to fee you owe the lender for lending you the money. As I'll show with numbers (thanks to a character named Catherine) in a future post, if you want to get ahead of your schedule by paying the loan down faster, apply the extra money, explicitly, to the principal you owe for the the best results.
It’s important to realize, however, that when you’re building equity in something paid for by a loan that has been amortized, in the beginning, you’ll build equity very slowly because the interest has been front-loaded on the loan. In the first pay period, you pay a huge amount of interest and a tiny amount of principal. In the next pay period, you pay slightly less interest and slightly more principal. This spreading out of a known quantity of interest, given the known life of the loan and a known interest rate is "amortization."
One consequence of how this system works is that, over time, the proportion of your payment each period which is interest decreases, and at the same time, the amount of your payment each period which is principal increases. There exists a symmetry in the principal and interest in amortized loans: early on, you pay almost all interest and almost no principal, and at the end, you pay almost all principal and almost no interest.
Remember that only the principal builds equity; the interest is simply to fee you owe the lender for lending you the money. As I'll show with numbers (thanks to a character named Catherine) in a future post, if you want to get ahead of your schedule by paying the loan down faster, apply the extra money, explicitly, to the principal you owe for the the best results.
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