This section on amortization accounting is based on articles written by The Mortgage Professor, Jack M. Guttentag, who is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. If you have any questions about mortgage products, you really should visit his site, mtgprofessor.com.
You have probably seen an amortization schedule for your home loan. When a bank makes your fixed-interest loan, it calculates a monthly payment which, if maintained unchanged through the remaining life of the loan at the then-existing interest rate, will pay off the loan over its remaining life. The amortization schedule shows how much will be applied to principal and interest every month until the loan is paid off.
The monthly payment is designed so that both interest and principal are paid every month. To put it as simply as possible, the interest portion of the payment is calculated by multiplying the principal balance by the interest rate and dividing by 12. The amount applied to principal is whatever is left after paying interest. Let's look at the example given by The Mortgage Professor:
The loan is for $100,000 at 4% for 30 years. The monthly payment is $477.42.
Interest due in month one: $100,000 x .04 divided by 12 = $333.33
principal paid in month one: $477.42 minus $333.33= $144.09
$144.09 is deducted from the principal balance, giving a new principal balance of $99,855.91
the interest due in month two is $99,855.91x.05 divided by 12 = $332.85
principal paid in month two: $477.42 minus $332.85=$144.57.
This process repeats itself for the life of the loan.
You might find the illustration of how mistakes snowball a helpful way to visualize this process. I convert the annual interest rate to a monthly interest rate.
step one: multiply the principal balance by the monthly interest rate to get the amount that should be paid to interest.
step two: subtract the amount paid to interest from the monthly payment. This amount is applied to principal
step three: subtract the amount applied to principal from the principal balance you used in step one. This amount is the new principal balance.