Definition
Amortization is the process of spreading out a loan into a series of fixed payments over time. Each payment covers both the interest expense and reduces the principal balance. In the early years of a loan, a larger portion of each payment goes toward interest, while in later years, more goes toward principal.
Formula
Where P is the principal loan amount, r is the monthly interest rate (annual rate divided by 12), and n is the total number of payments (loan term in years × 12).
Example
30-Year Mortgage Amortization Example
For a $300,000 mortgage at 4% interest for 30 years, the monthly payment would be approximately $1,432. In the first payment, about $1,000 goes toward interest and only $432 toward principal. By year 20, the ratio flips—with about $1,100 going to principal and only $332 to interest. By the final payment, nearly the entire amount goes to principal.