Amortization, Principal and Interest Payments
Understanding Amortization, Principal and Interest and how they affect on paying larger debts faster
Amortization
The rates, at which interest is figured, usually based on an Annual Percentage Rate. For instance, if a person buys a car for ten thousand dollars and they have a loan based on an amortization rate of ten percent annually. The first year they will have to pay one thousand dollars in interest rates alone.
The interest which people are charged will be the substantial portion of their monthly payment for the first couple of years with most vehicle purchases and for the first five to ten years for most mortgages. Knowing how the amortization works is a key factor in understanding how to properly manage your large debts.
Principal Amount
The principal amount or the principal is the actual amount of the loan itself. Whether it is a personal loan, a business loan or a home loan, the loan is based on the principal amount borrowed. The interest is amortized based on the principal amount and the actual amount of interest paid will be on the remaining principal of the loan at any given time.
Going back to the over-simplified example of our new car buyer; they borrowed ten thousand dollars to buy a new car. The interest alone based on the ten percent interest rate will be amortized at ten percent over the course of the first year. If they were paying one hundred dollars a month on their car payment, they would make a total of twelve hundred dollars worth of payments the first year.
This would mean that they paid the one thousand dollars in interest payments and only two hundred dollars on the actual principal of the loan. Looking at it this way, it is easy to see how so much of the payments they make is paid towards the interest and not on the principal of the loan.
Carrying this over into the second year, they now have a principal loan amount of nine thousand eight hundred dollars. This can be figured by the fact that they only paid two hundred dollars on the principal of the loan over the first year. Since the rates are annual percentage rates, they are based on the payments over the course of a year.
Keeping on the same loan, the second year they would still have to pay nine hundred and eighty dollars in interest. Thus, at the end of the second year of making payments, they would still have a principal loan amount of nine thousand five hundred and eighty dollars. Keep on going at this rate and it is easy to see how banks can make so much money and payments get dragged out for so many years.
Interest Payment
The interest payment is the amount of interest paid on the principal amount of the loan. As we saw in our example; the person who borrowed ten thousand dollars to buy a car, paid ten percent interest compounded annually. That means that for the first year, the actual interest paid was one thousand dollars and the actual payment that went towards the principal amount of the loan was only two hundred dollars.
When our first person made two extra payments every year, they only made regular payments. Thus they were still paying the full amount in interest and principal payments. They never saved any money because even though they were still paying off the loan early, they never did anything to decrease the actual interest payments which were due and were based the entire time on the principal amount of the loan.
While the interest rates used here in the examples are based on tens so that they are easy to understand, this is not always the case in financial institutions. It is not that the financial institutions are doing anything at all which is illegal or even unethical. However, they earn their profits from the interest which they earn on the money that they loan out. Would you go out of your way to tell someone how to keep you from making a profit on items that you are selling to them to earn your living?
Since the interest item is the only place that there is an actual profit, it is the only place that you can actually save money and decrease your payments. Why our first home buyer never saved any actual money will become painfully obvious in the next section.
