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What Is Loan Amortization And How Does It Work?

If you have a loan - home, car or any other loan - you must familiarize yourself with the process of Loan Amortization. Here, we explain to you how your EMI payments "amortize" your loan, as well as explain to you why its important for you to be familiar with this process.

EMI payments and Loan Amortization

Did you know that when you make an EMI payment on your loan, it comprises two items? Firstly, you pay the cost of the loan, i.e., the interest charged by the lender. Secondly, you also pay down some of the loan that you took, i.e., the repayment of the principal amount of the loan.

Over time, your EMIs result in a gradual reduction in the outstanding principal amount of a loan, i.e., you keep reducing your indebtedness. This process of paying down the loan is referred to as Loan Amortization.

The interest component of the EMI payment depends upon the remaining loan balance at any point in time. As you amortize the loan, the total principal amount outstanding reduces with every progressive EMI payment. As a result, the interest component of the EMI keeps reducing over the life of the loan. The EMI amount stays the same but the mixture of principal repayment and interest cost comprising the EMI changes.

Let's demonstrate this through an example. Krishna has took a home loan in 2010 with the following details:

• Principal loan amount: Rs 10 lakhs
• Term period: 10 years
• Rate of interest: 9%
• EMI: Rs 12,668

During the early life of the loan, for his EMI payments, Krishna would pay more towards the interest component, and a relatively smaller amount towards the principal repayment. The table below shows the EMI payment for the last month of every year the loan is outstanding. The EMI payments are monthly, and so for a 10-year loan there will be 120 payments. However, for ease of explanation and due to space constraints, we have showed only the EMI payments at the end of each year the loan is outstanding.

As you can see from the table, though the EMI is always the same, in the early life of the loan the interest cost is high, but by the time the last installment is made, the interest cost is almost negligible, with most of the EMI going towards paying down the outstanding loan amount. At the end of the 10-year tenure, the loan extinguishes itself because you have paid back your entire debt through your recurring EMI.

Here is a graphical representation of the above table, demonstrating how the interest component declines over time, and how by the time the loan reaches maturity the bulk of the EMI comprises principal repayment.

Fortunately, this is a calculation that almost any loan advisor can do for you. Alternatively, you can find many loan amortization calculators that can do these calculations for you, so you don't have to struggle with calculating these numbers on your own.

Why is this important?

The natural question for you to ask when you see the above table and graph is "its too complicated, why do I need to know this?"

It's important for you to know this for three reasons:

1. Know how much of your loan remains: If you understand loan amortization, then you can easily identify how much of your principal amount (your loan) have you paid back and how much remains to be paid. Your ability to take on additional loans depends upon what is the existing debt that you have outstanding and its only through a loan amortization schedule that you can get this info.


2. Decide when to pre-pay or refinance your loan: You might consider refinancing your loan with another lender if you find your existing interest rate on the loan to be high relative to what current interest rates might be. However, if your interest component of the EMI payment is already quite low because you are towards the end of the life of the loan, it's probably not worth the hassle. Also, once you factor in the hidden costs, in the form of any refinancing penalty you might be charged, it probably won't make economic sense to refinance. Through your amortization schedule you can easily tell the amount of interest cost you are paying and can then quickly identify whether it makes sense for you to refinance or not.


3. Tax related issues: Some loans, like home loans, will give you tax benefits for interest repayment under Section 24 of the IT Act as well as benefits for principal repayment under section 80C. If you have your amortization schedule handy, you can easily do some financial planning to efficiently plan your taxes for the coming years. You can see how much principal you are likely to repay during the coming year, and accordingly choose your amount and type of 80C deduction.

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