Understanding the distinction between amortization and interest is crucial when managing loans or financial planning. Here’s a breakdown of these concepts:
💡 What Is Interest?
Interest is the cost you incur for borrowing money. It’s typically expressed as a percentage of the principal (the original loan amount) and can be calculated in different ways:
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Simple Interest: Calculated solely on the principal amount. For example, if you borrow $10,000 at a 5% annual simple interest rate for one year, you’ll pay $500 in interest.
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Compound Interest: Calculated on the principal and the accumulated interest from previous periods. This means you pay interest on both the original amount and the interest that has been added over time.
📘 What Is Amortization?
Amortization refers to the process of repaying a loan over time through scheduled, periodic payments. Each payment covers both interest and a portion of the principal. Over the life of the loan:
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Early Payments: A larger portion goes toward interest.
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Later Payments: A larger portion goes toward reducing the principal.
This structure ensures that the loan is fully paid off by the end of its term.
🔍 Key Differences
| Aspect | Interest | Amortization |
|---|---|---|
| Definition | Cost of borrowing money | Process of repaying a loan over time |
| Calculation Basis | Based on principal (and possibly accrued interest) | Structured schedule covering both interest and principal |
| Payment Structure | Varies (can be fixed or variable) | Regular payments with changing interest/principal ratios |
| Loan Types | Applicable to all loans | Common in mortgages, auto loans, and personal loans |
🧮 Example
Consider a $100,000 mortgage at a 5% annual interest rate over 30 years:
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Interest: Initially, the monthly payment includes a higher interest portion because it’s calculated on the full principal.
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Amortization: Over time, as the principal decreases, the interest portion of each payment decreases, and the principal portion increases.
This gradual shift ensures the loan is paid off in full by the end of the term.
Understanding both interest and amortization helps in making informed decisions about loans and managing repayments effectively.