The process of paying down a loan — any loan — is called loan amortization. An EMI, or equal monthly installment, is what allows you to have a consistent monthly payment while you decrease your indebtedness. Even though you’re paying interest and principle simultaneously, the loan amortization and EMI systems allow you to plan your budget around a base number each month.
Principle and Interest
The amount of principle vs. interest you are paying each month depends on your remaining balance at any given time in the life of your loan. As the loan amortizes, the total principle amount reduces with each timely EMI payment. This allows for the interest to reduce as well. The EMI stays the same but the ratio of its components — the amount of principle and interest — will reverse as time passes. While you start out paying mostly interest each month, your principle lowers, the amount of interest you owe will also lower, making the percentage of principle in each successive EMI greater than in the previous month.Why It’s Important
Although it seems complicated, understanding amortization is important because it allows you to easily identify how much of your principle loan amount remains. If you need to take out an additional loan, it is important to understand your preexisting debt. Part of what affects your credit score (and viability as a loan candidate) is how much money you already owe. Understanding amortization will also help you decide how much to prepay and if or when it might be viable to refinance your loan. Finally, some loans can give you tax benefits for interest and/or principle repayment. With a comprehensive amortization plan, tax planning can lead to a stronger grasp on your personal finances and will allow for more strategic financial planning.
It’s Worth Figuring Out
Amortization schedules are a daunting thought, but they aren’t that hard to figure out once you grasp the concept; although your payments stay the same, the application of the payments shifts between principle and interest. Schedules are often included with your loan agreement and can be followed chronologically for easy calculations throughout your repayment period. Any steps you take towards understanding your loan and its payment plan will make for a much easier process of managing your loans.