Amortization is a key concept in your financial life. If you don’t have a clear amortization definition, you’ll find it difficult to understand how a mortgage works. And amortization is also critical if you want to budget effectively (much more on that shortly). Can you think of any more important financial concept? There aren’t many. Let’s get to work.
What is amortization?
Let’s break it down and look at what an amortized loan is, and then we’ll look at how to amortize your spending.
What is an amortized loan?
If your loan has a payment schedule that includes both interest and principal in each payment, you have an amortized loan. Because your monthly payments include some principal repayment, your principal balance goes down every month. And because the principal is reduced each month, the interest charge (not the rate) is also lower. That’s the magic.
Amortized loans have level monthly payments. As a result, an increasing amount of your payment goes toward principal every month. Let me illustrate:
Let’s say you have a $100,000 mortgage. The terms of the loan are 30 years at 4%. The monthly payments for such a loan are $477.42. So if you pay $477.42 a month for 30 years, you will pay off your debt.
Let’s break this down by looking at what happens over the course of a few months.
In January, like all other months, the payment is $477.42. The interest of 4% a year accrues during that first month, again, like every month. If you want to know how much interest you will be charged this first month, you simply take 4%, divide it by 12 and multiply it by the balance of $100,000. It works out to $333.33.
But since the payment is $477.42 and the interest is only $333.33, there is $ 143.87 that is applied towards the $100,000 debt. So if you do the math, you’ll see that the balance drops to $99,856.13 at the end of the first month. It’s not a big drop, but it counts.
As you can see by the grid below, an ever-increasing amount of the payment goes towards the balance each month, further reducing the interest cost. And as the interest cost goes down, an ever-growing percentage of the fixed payment is applied towards the balance, reducing it still further. You see, it’s a beautiful endless cycle that repeats itself over and over until the mortgage is paid off.
See, that wasn’t so difficult? Let’s move on.
How do you amortize expenses?
Amortizing expenses if a bit different than amortizing a loan. Basically, you amortize your expenses by differentiating between what you spend in a month vs. what something really costs you. I know that sounds confusing. Let me explain by way of example.
Let’s say you pay your car insurance bill of $1,200 in January. Your expense isn’t $1,200 in January just because you paid that $1,200 bill in January. We have to amortize that $1,200 over the entire year. You use the insurance throughout the year, so it’s actually a monthly cost of owning a car, even though you pay the bill once a year. So the amortized insurance expense is actually $100 every month – including January – and not $1,200.
The concept of amortizing your expenses is very important for budgeting. By amortizing all your expenses you will know how much it really costs you to live and you won’t be taken by surprise. That is the purpose of the exercise.
How do you apply this idea?
Let’s say you are a student. It costs you $500 in rent, $400 for food and $100 for miscellaneous. These are your monthly recurring expenses and they total $1,000. But you also pay for books and tuition twice a year. Let’s say that comes to a total of $12,000 (for the entire year).
You amortize the books and tuition and it works out to be $1,000 a month. ($12,000 divided by 12 months.) You take that $1,000 and add it to your $1,000 a month for rent, food and miscellaneous. As a result, you know now that you must have $2,000 a month in income in order to pay for school.
You can see that if you plan for $2,000 you’ll be far better off than if you only plan for $1,000 and then have to scramble when it’s time to pay for books and tuition. Unfortunately, most people do not amortize their expenses, and as a result they find themselves always chasing their financial tail.
Do you amortize your expenses? When did you start doing so? What difference has it made?