Amortization is a gradual reduction of a loan debt through periodic installment payments of principal and interest, calculated to pay off the debt at the end of a fixed period.
Principal is the amount that is loaned to you.
Interest is the amount that you are paying for the right to borrow that money. Think of it like rent on money.
With each mortgage payment that is made, a portion of the payment is applied toward reducing the principal, and another portion of the payment is applied toward paying the interest on the loan. An amortization table shows this ratio of principal and interest, and demonstrates how a loan debt decreases over time.
Let’s use a really basic example to help explain this concept. You borrow $10 with $2 interest a month. Every month you pay $3.
10+2 = 12-3 = 9
9+2 = 11-3 = 8
8+2 = 10-3 = 7
7+2 = 9-3 = 6
In this example, at the end of 10 months you owe nothing, and the loan is fully amortized.
A fully amortized loan is a loan that has been completely paid off at the end of the loan term.
When we hear the word negative, we generally think of it as a bad thing. For the most part, negative amortization is no different. With negative amortization, the gist of it is that you keep making your payments on time, but your debt keeps increasing! There are circumstances where this can be appropriate, but traditionally this has gotten people into a lot of trouble.
Let's simplify this using the first example of borrowing $10 with $2 interest a month, but now every month you're only paying off $1.
10+2 = 12-1 = 11
11+2 = 13-1 = 12
12+2 = 14-1 = 13
13+2 = 15-1 = 14
After 10 months my debt has doubled to $20!!! My debt has gone up! That is negative amortization.
You may be thinking, is there something in the middle? and the answer is yes. When you hear the term straight note, it is referring to a loan where you are just paying the interest, with the principal balance due in one lump sum at the end of the loan term.