Edited on 27.12.2021
Amortization refers to the process of paying off debt over time in regular equal payment consisting of interest and principal loan amount sufficient to repay the loan in full by its maturity date. Amortization also refers to the spreading out of capital expenses (similar to depreciation) related to intangible assets over a specific duration, normally over the asset’s useful life. Amortization of capital asset is done for the purpose of accounting and tax purposes.
Now a day, it is common that banks fix number of equated monthly installments (EMI) for Home loans, Vehicle Loan, 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.
For example you have availed of a loan of 50 lakhs at the interest rate of 9% repayable in 240 months; the EMI for the loan repayment is worked out as under.
The formula for calculation of EMI is E= P x R x (1+R) ^N / [(1+R) ^N)-1] Where E= EMI, P = Principal amount of the loan, R = Rate of interest, N = Number of monthly installments.
Interest @ 9% P.A =0.0075per month
E= P x R x (1+R) ^N / [(1+R) ^N)-1]= (5000000 x 0.0075) x (1.0075)^240/{ (1.0075^240)-1}
(5000000 x 0.0075)= 37500
(1.0075)^240/{(1.0075^240)-1}=6.00915/5.00915=1.19963
EMI E=37500 x1.19963=44986. It means you have to repay equated monthly installment of Rs 44985 for 240 months to liquidate your loan of Rs.50 lacs.
Now your first payment of Rs.44986 is apportioned as under:
Interest for first month for the loan amount of Rs.500000 is (5000000 x 0.0075) i.e. Rs. 37500. So Rs.37500 will be towards interest out of EMI Rs.44986 paid by you and remaining Rs.7486 will be paid towards reduction of principal loan amount i.e. 5000000-7486=4992514
The second month, interest will be calculated on loan balance of Rs4992514 that is 4992514 x 0.0075 =37443.85 .So Rs.37443.85 will be towards interest out of EMI Rs.44986 paid by you and remaining Rs.7542.15 will be paid towards reduction of principal loan amount i.e. 4992514- 7542.15= 4984971.85. Hence loan outstanding after payment 2nd installment will be 4984971.85. Likewise, the loan balance and interest on loan continues to reduce every month. In the penultimate month loan outstanding will be Rs.44650. From the last and final EMI of Rs 44986 , Rs.335 will be adjusted towards interest and Rs.44651 will be adjusted towards the principal loan amount, and the loan outstanding after the 240th installment will be zero.
