Amortization is the process of paying off loan amount over a period with regular equal payment. Now a day, it is common that banks fix number of equated monthly installments (EMI) for Home loans, consumer loans etc. for repayment of loan granted by them typically amortizing their loan.
How it works?
A portion of each installment paid by the borrower goes towards;
- The interest costs of the loan.
- Reminder is reducing loan balance (Principal amount).
In this process, though the portion of payment is applied towards principal and another portion towards payment of interest, at the initial stage, interest costs of the loan are highest and pay off of loan balance is very small. This is more so in case of long-term loans, where the majority of each periodic payment is an interest expense. In the other words, the borrower does not make much progress on debt repayment during the early years of loan. As time goes on, more and more of each payment goes towards principal and less in interest each month.
Although, amortization is most common with EMI payments of loans, it is an accounting term that can apply to other types of balances.