How is a loan amortized?

There are different amortization methods, although the most used in Spain is the so-called French amortization method:

  • Its main characteristic is that what we have to pay for the sum of amortized capital and interest on each receipt does not vary. That is, we always pay the same amount (as long as the interest rate remains constant).
  • This means that, of the money we pay, over time, the amount destined to the payment of interests decreases and the part that is destined to return the capital increases.

Example:  if we request a loan of 10,000 euros to be repaid in 4 years, at a fixed annual interest rate of 6%, the constant periodic installment to be paid in each of the four years is: 2,885.91.

Now, in the first year the interest generated by the loan is: 10,000 x 0.06 = 600, then the amount that is used in that first year to reduce the debt is: 2,885.91 – 600 = 2,285.91, which This is what we call the first year amortization fee.

At the beginning of the second year, the outstanding debt that would earn interest would be: 10,000 – 2,285.91 = 7,714.09. And, therefore, the interest rate for the second year is: 7,714.09 x 0.06 = 462.85.

The amount that is used to reduce the debt in the second period is: 2,885.91 – 462.85 = 2,423.07, and so on during the four years of the loan.

This recurrence is reflected in the amortization table (the evolution of the payments we make) of our loan, which would be the following (figures in euros):

YearCapitalInterestsQuota (cap. + Int.)Pending debt
12,285.91 600.00 2,885.91 7,714.09 
22,423.07 462.85 2,885.91 5,291.02 
32,568.45 317.46 2,885.91 2,722.56 
42,722.56 163.35 2,885.91 0.00 

In long-term operations, it is usually the case that, of the total amount of the receipt that we pay, the part destined to the payment of interest is greater than that dedicated to amortizing capital, this circumstance being more appreciable in the first years of the loan.

Example:  if we consider a loan of 100,000 euros to be paid in 15 years, at a fixed annual interest rate of 5.25%, the evolution of the composition of the installments would be:

YearCapitalInterestsQuota (cap. + Int.)Pending debt

As can be seen in the graph, although the installment is constant throughout the term of the loan, initially more interest is paid because the outstanding principal is very high. However, as the capital decreases, the interests paid for it also do so, so that the part of capital amortization included in the installment increases.

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