What Is Amortization?
Amortization is an accounting technique that involves spreading out the cost of a debt over a period of time by repaying the debts in installments. Amortization involves allocating the cost of the debt in a systematic manner, both for accurate financial reporting and better planning of expenses. Amortization schedules are used by lenders, such as financial institutions, to produce a loan repayment schedule based on a specific maturity date.
When you take out a loan, there will be an interest rate, along with a payment term. As you pay down your loan amount, there is less principal to charge interest on, so your interest amount will be less month after month. When there is less principal to charge on, interest will gradually decrease as the loan balance decreases, which means that even if you make the same payment month after month, more of that payment will go towards paying off the debt, rather than to interest. For example, if you are paying $1,000 every month, the first month will have the highest amount of interest that will have to be taken out of that payment. As the months go on, your monthly payment stays the same, so there is less and less interest that is taken out of your payment and more of your payment goes directly to paying off the loan.
What Is Negative Amortization?
Negative amortization happens when the payments of a loan are lower than the accumulated interest, which causes the borrower to owe more money despite making the scheduled payments.
Example: You take out a loan for $20,000 with an interest rate of 4% and you are making monthly payments. Each year, your $20,000 loan will accrue $800 of interest, which is $66.67 per month. Therefore, if you’re only making a $50 monthly payment, the remaining $16.67 of interest will be added onto your loan amount. That larger loan amount will then be eligible for the 4% interest rate, and your interest amount that needs to be paid will also increase each month.