Understanding Loan Amortization & Its Impact On Refinancing Decisions

September 15, 2022

 

Sometimes, you might be left wondering how your loan repayments are worked out - how much takes care of the principal loan amount and how much is used to pay for the interest. Well, you can use the amortization schedule of your loan to find out.

So, what is a loan amortization and how does it work? Loan amortization can be defined as the process that is used to find out the interest and principal amounts whenever a person is repaying a loan.

Loans such as mortgages accumulate a lot of interest, meaning that you might find yourself paying more interest than the principal loan in the first few years. That notwithstanding, understanding loan amortization and its impact on refinancing decisions are very important.

Loan Amortization and How it Works

As discussed above, loan amortization is a term used to describe the process through which a person pays a loan, especially when and how they pay the interest and principal during the term of the loan. This can also help you understand the different factors influencing your interest rates.

This does not mean that the amount of money you pay every month is going to change. However, as you repay your loan every month, the amount of money that goes to the loan’s interest rate and the principal amount can change.

Most of the time, most lenders get more money for interest compared to the principal amount in the first few years of the loan’s term. This is the time when the amount of money you need to pay is the highest.

However, after a few years, this changes and you get more money taking care of the loan’s principal amount. The interest keeps on going down as you get closer to the end of your loan term.

How it Works

Let us take an example where you have taken a loan worth $250,000 that has 4% interest and a term of thirty years. Most lenders will ask you to pay about $1,193.54 every month, being payment for both the loan's principal and interest rate.

At the beginning of the term of the loan, $360.20 will be used to settle your principal amount while $833.33 will go towards settling your interest rate. As you continue making payments, the principal amount will keep on increasing while the interest amount keeps on decreasing.

In the last payment, you will pay only $3.97 in interest, while all the other money goes to the principal amount. This shows you how loan amortization works.

Calculating Your Loan Schedule

Getting the math discussed above right might be a challenge for a lot of people. Fortunately, you can use a home loan calculator or an amortization calculator. When doing the calculation, make sure that you have the term of the loan, the interest rate, and the loan amount.

After feeding the calculator with the required details, you will get an amortization table that has all the important information that you need.

This might include things such as;

  • The total amount of interest you will be required to pay throughout the term of the loan.
  • The amount of money that pays for your principal loan and that pays for your interest every month.
  • The amount of interest you will be required to pay for other loan terms, for example, 10, 15, 20, or 25-year loan terms.
  • The balance of your loan every month throughout the term of the loan after each monthly payment. This is important in helping you find out when you can forget about mortgage insurance due to the equity you have in your home.
  • The amount of money you can save if you made extra payments when repaying your loan.
  • The amount of money you might save if you refinanced your mortgage, but at lower interest rates.

The Impact of Amortization on Refinancing Decisions

Amortization may have an impact on your refinancing decisions. Refinancing a loan means that the loan that you currently have is replaced with a new one. This resets the term or the clock on the terms you had and loan repayment.

When this happens, it is assumed that you have started repayment of your loan again, and a bigger percentage of the amount of money you pay every month goes towards the interest rate. However, you do not have to pay all this interest.

You can refinance your loan into a 10, 15, or 20-year loan if you had a 30-year one. This is important in accelerating amortization and helping you repay your loan quickly.

When applying for a loan, it is important to understand the amount of money you are going to spend repaying the loan as well as the options you have when it comes to refinancing. This is why you also need to understand loan amortization and its impact on refinancing decisions.

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Thomas P
I believe in making the impossible possible because there’s no fun in giving up. Travel, design, fashion and current trends in the field of industrial construction are topics that I enjoy writing about.

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