Let’s start off with a basic understanding of how debt is paid off. While the concept is pretty simple, it’s surprising that this is not common knowledge. A clear idea of how debt accrues and is paid off is useful to take control of the debt repayment strategy that works best in your interest.
Amortization is a method to calculate the repayment of a loan over time. From the day you borrow money from a lender, the lender accrues interest on the amount outstanding. A portion of every repayment goes into repaying the accrued interest and the remaining amount of your instalment reduced the principal, or loan amount left to pay back. An amortization schedule is drawn up for a monthly repayment amount at an agreed upon interest rate. This amount is usually a regular monthly amount (Also called as EMI or Equated monthly instalment), so the borrower can plan for arranging the agreed upon amount on a monthly basis.
Amortization schedules are easy to generate on an excel sheet, and we also have many versions online. A basic skeleton of an amortization schedule is as below:
|Date||Principal (Month Start)||Annual Interest Rate||EMI||Interest Accrued||Principal Repaid||Principal (Month End)|
For floating rate loans, the interest rate changes on a periodic basis (usually quarterly). Consequently, the schedule could incorporate calculations by varying the interest rate for particular months.
Prepayments, in India at least, are applied to the principal outstanding. So, if the borrower approaches his lender to prepay a certain portion of the loan, the amount reduces the principal so the interest accumulating monthly jumps downward.
What can be measured, can be improved. An amortization schedule allows the borrower to project the loan into a series of cash outflows from his account during the years that follow. This enables appropriate planning of the future – examining the impact of changes in interest rate, planning for prepayments and also for increasing the EMI – with an approximate view of how the loan repayment will be modified by factors within and outside the borrower’s control.