Simply put, interest is the cost of borrowing money.
Interest is expressed as a percentage of the loan amount. For example, suppose a consumer wanted to borrow $1,000 and pay it back in exactly one year. If the interest rate is 5.0 percent, it’s a simple calculation: just multiply the loan amount by the interest rate. So $1,000 * .05 = $50. In one year, then, the borrower would repay the lender $1,050.
However, this basic calculation, called simple interest, is not the way interest on most loans is computed. Instead, interest is compounded. If the $1,000 loan in this example were compounded monthly, for example, the calculation would look like this:
Each month, the interest charge is equal to the annual interest rate / 12 months, multiplied by the loan balance. Each month, the interest owed is added to the balance, so the borrower is paying interest on the interest. Instead of $1,050 at the end of a year, the borrower owes $1,051.16. That’s the power of compounding.
When borrowers take out mortgages, however, they don’t normally repay them all at once. They pay in installments, and the payments are structured so that the loan balance will equal zero at the end of the loan term. This is called amortization. Each payment is enough to pay for the interest charge for that month, plus a little extra – that extra goes toward reducing the loan balance. Every month, the balance gets a little smaller, so there is less interest expense and a bigger part of the payment goes toward reducing the loan balance.
Here’s what it looks like when the borrower pays the $1,000 loan off in monthly installments of $85.61. Total interest paid? $27.29. That’s the power or amortization.
