Understanding Loan Payoff & Amortization
Most loans, such as mortgages and auto loans, are amortizing loans. This means each monthly payment covers the interest accrued for that month plus a portion of the principal balance. As you pay down the principal, interest portion decreases, allowing you to pay off the loan faster.
The Impact of Extra Payments
Making extra payments is one of the most effective ways to save money. Even a small extra amount applied directly to the principal can significantly shorten the loan term.
- Reduces Principal Faster: The extra money goes directly to the loan balance, not the bank's pocket.
- Lowers Interest: Since interest is calculated on the remaining balance, a lower principal means less interest accrues over time.
- Flexibility: You don't necessarily have to commit to a higher payment forever; you can make one-off payments when you have spare cash.
Amortization Formula
The standard monthly payment is calculated using the amortization formula:
M = P [ i(1 + i)^n ] / [ (1 + i)^n – 1 ]
Where P is the principal loan amount, i is the monthly interest rate, and n is the number of months.