Amortization refers to reducing current debt by paying the same amount each period (usually monthly). With amortization, payment of debt consists of payment of principal (principal) and payment of interest (interest). Principal is the outstanding loan balance. As more principal is paid, the interest payments decrease. Over time, the portion of interest payments each month will decrease and the portion of principal payments will increase. Amortization is usually encountered when making a mortgage or car loan, however, in accounting amortization also refers to the periodic reduction in the value of an intangible asset over time.
Step
Method 1 of 2: Calculating Interest and Principal Loans in the First Month
Step 1. Gather information to calculate loan amortization
You need the principal amount of the loan and the interest rate (interest rate). To calculate amortization, you need the terms of the loan and the payment amount for each period. In this case, you would calculate the monthly amortization.
- The principal amount of the loan is the current outstanding balance of the loan (Rp1,000,000,000).
- The interest rate (6%) on the loan is the annual interest rate. You need to convert it to a monthly interest rate.
- The loan terms are 360 months (30 years). Since amortization is a monthly calculation, the year is converted to months.
- The monthly payment amount is IDR 5,999,500. The amount of payment each month remains the same, but the portion of the principal and interest payments will change each month.
Step 2. Prepare a spreadsheet
This calculation will involve several moving parts and is best done on a spreadsheet as you will need to enter all relevant info in the account heading column, for example: Principal, Interest Payments, Principal Payments, and Ending Principal Balance.
- The total number of rows under the headings is 360 to record the monthly payments.
- The worksheet will make calculations fast because if done correctly, the equation is only entered once (or twice, since you are using the previous month's calculations to complete all subsequent calculations).
- If it's entered correctly, simply drag the equation down and fill in the remaining cells to calculate the amortization over the life of the loan.
- It may be best if you set aside a separate set of columns and include the main loan variables (eg monthly payments, interest rates) because you will be able to see the impact of changes on all variables over the life of the loan.
Step 3. Calculate the interest portion of the monthly payments in the first month
This calculation involves several steps. You will need to convert the annual or semi-annual interest rate to monthly. The monthly interest rate is used to calculate the interest each month.
- Loans that are amortized, such as mortgages or cars, have monthly payment terms. Therefore, you need to calculate the interest and principal portion of each payment each month.
- Find the monthly interest rate. From the previous example, (annual interest rate of 6% divided by 12 = monthly interest rate of 0.005).
- Multiply the principal amount by the monthly interest rate: (Rp1,000,000,000 principal times 0.005 = first month interest Rp5,000,000).
Step 4. Calculate the portion of the principal payment in the first month
Subtract the amount of the monthly payment with the corresponding month's interest to calculate the portion of the principal payment.
- Subtract the related month's interest payment from the monthly payment to get the principal payment: (Rp5,995,500 payment – Rp5,000,000 interest = Rp995,500 principal payment).
- Because some of the principal has been paid, the amount of interest on the principal will decrease. Each month, the principal portion of the monthly payment will increase.
Step 5. Use the new principal amount at the end of the first month to calculate the amortization for the second month
Each time you calculate amortization, you subtract the principal amount paid in the previous month.
- Calculate the principal amount in the second month: (Principal Rp1,000,000,000 – principal payment Rp995,500 = Rp99,904,500).
- Calculate the interest in the second month: (Principal Rp99,904,500 x 0.005 = Rp4,995,000).
Step 6. Determine the principal payment in the second month
As calculated in the first month, the interest in the relevant month is deducted from the total monthly payment. The remaining amount is the principal payment for the month concerned.
- Calculate the principal payment in the second month: (Rp5,995,500.55 - Rp4,995,000 = Rp1,000,500).
- The principal payment in the second month (Rp1,000,500) is greater than the first month (Rp995,500). Because the total principal balance decreases each month, the interest paid every month is also reduced so that the portion of interest payments in monthly payments is also reduced. In the first month the interest paid is IDR 5,000,000. In the second month, the interest paid is only IDR 4,995,000.
- Because the required interest payments are reduced, the portion of the monthly principal payments increases.
Method 2 of 2: Calculating Amortization for the Entire Loan
Step 1. Analyze emerging trends over time
You can see the loan principal balance is decreasing every month. As the principal amount decreases, the interest paid also decreases. Over time, the amount that grows on each monthly payment goes towards the principal of the loan.
- Calculate the new principal balance to calculate interest in the third month: (Rp999,004,500 - Rp1,000,500 = Rp998,004,000).
- Calculate interest for the third month: (Rp.998.004,000 x monthly interest rate of 0.005 = Rp.4,990,000).
- Calculate the principal payment in the third month: (Interest payment Rp. 5,995,500 – interest in the third month Rp. 4,990,000 = Rp. 1,005,500).
Step 2. Consider the impact of amortization at the end of the loan term
You will notice, over time the amount of interest paid decreases. The portion of principal payments on each loan payment increases over time.
- Interest payments decrease to near zero. In the last month of the loan period, the total interest payment is Rp.29,800.
- At the end of the loan period, the principal repayment portion was (Rp5,963,700), an amount that is close to the total loan repayments.
- The total loan principal balance at the end of the loan period is Rp0.
Step 3. Use the concept of amortization to make smart financial decisions
Since mortgages and auto loans use amortization, you need to understand this concept. You can use this knowledge to manage your personal debt.
- Whenever possible, make extra payments to reduce the principal amount faster. The faster the loan principal can be reduced, the amount of interest paid will also decrease.
- Consider the interest rate on outstanding debt. Your extra payments will have the greatest impact on the debt with the highest interest rate. You should reduce the principal amount of the debt with the highest interest rate.
- You can find an amortization calculator online. Use this calculator to calculate the interest you save if you make extra payments. Say, your extra payment reduces the principal from $100,000 to $99,000.
- Use $100,000 and calculate the amortization over the life of the loan. Change the principal from IDR 100,000,000 to IDR 99,000,000 and calculate it again with a calculator. Look at the total interest paid over the life of the loan. You'll see the difference, based on an extra principal payment of IDR 1,000,000.
