Amortization

What amortization does

Amortization is the slow grind of retiring a mortgage through regular payments. Each payment is split in two: one part covers the interest owed on the balance for that period, and the rest chips away at the principal. Because the payment amount is set at the start, the only thing that changes month to month is the mix inside it. That shifting mix is the heart of the concept and the source of most exam questions about it.

How the payment split changes

Early in the loan the balance is large, so interest eats most of the payment and principal barely moves. As the balance falls, the interest charge shrinks and more of the same payment reaches principal. By the final years the payment is almost entirely principal.

Stage of a 30-year loan	Interest share	Principal share
First few years	Largest	Smallest
Middle years	Roughly even	Roughly even
Final years	Smallest	Largest

A worked example

Take a $100,000 loan at 6% interest for 30 years. The monthly principal-and-interest payment is about $599.55. In the first month, interest is the monthly rate (6% / 12 = 0.5%) times the $100,000 balance, or $500. The remaining $99.55 goes to principal, so the balance drops to $99,900.45. In month two, interest is 0.5% of the new, smaller balance, which is slightly less than $500, so a little more of the payment reaches principal. Repeat that for 360 payments and the balance lands at zero.

Fully amortizing versus interest-only and balloon

Not every loan amortizes the same way, and the exam relies on the differences:

• Fully amortizing. The payment is sized so the balance reaches exactly zero at the end of the term. A 30-year fully amortizing loan has a zero balance after the 360th payment.
• Interest-only. For an initial period the borrower pays only interest and principal never falls. The balance stays put until the interest-only period ends.
• Balloon. Payments are calculated on a longer schedule, but the entire remaining balance comes due as a lump sum at a set date, well before the nominal term.

How it appears on the exam

Questions come in three shapes. One asks what is true of an amortizing loan, where the correct answer is that each payment includes principal plus interest and that interest is paid in arrears. Another gives a fully amortizing loan and asks the balance at the end of the term, which is always zero. A third describes an interest-only or balloon structure and asks what happens to the balance. Lock in the direction of the split, interest falling and principal rising, and these questions become routine.