Why Does Interest Charged Fall in an Amortization Schedule?

An amortization schedule is a detailed breakdown of periodic loan payments, typically for loans like mortgages or car loans. It visually represents how each payment is applied over the life of the loan. A common observation within these schedules is that the portion of each payment allocated to interest steadily decreases over time.

Amortization Schedule Basics

An amortization schedule outlines each payment a borrower makes, showing how much goes towards the principal and how much covers the interest. Principal refers to the original amount borrowed, while interest is the cost charged by the lender for the use of that money. Each payment on an amortizing loan is a fixed amount, but its composition changes. Early payments consist largely of interest, with a smaller portion reducing the principal balance. As the loan progresses, this allocation shifts.

The Impact of Principal Repayment

The declining interest portion in an amortization schedule stems from how interest is calculated. Interest is always computed based on the outstanding principal balance of the loan. With each payment, a portion reduces this principal balance. As the principal balance decreases, the base upon which the interest is calculated also shrinks.

Even though the interest rate on a fixed-rate loan remains constant, the dollar amount of interest charged goes down because the principal amount outstanding has been reduced. For a fixed payment amount, a smaller portion is needed to cover the interest. Consequently, a larger share of that same fixed payment can then be applied directly to further reduce the principal. This systematic reduction of the principal balance means less interest is owed, allowing more of the payment to go towards the principal, accelerating the loan’s payoff.

Seeing it in Action

To illustrate, consider a hypothetical loan of $10,000 at a 6% annual interest rate, repaid over three months. The fixed monthly payment for this loan would be approximately $3,366.71.

For the first payment, interest is calculated on the full $10,000 principal. This results in an interest charge of $50.00 ($10,000 multiplied by the monthly interest rate of 0.5%). The remaining portion of the $3,366.71 payment, which is $3,316.71, is then applied to reduce the principal balance, bringing it down to $6,683.29.

When the second payment is made, interest is calculated on the reduced principal balance of $6,683.29. This yields an interest charge of approximately $33.42 ($6,683.29 multiplied by 0.5%). The principal portion of the second payment then increases to $3,333.29 ($3,366.71 minus $33.42), further reducing the outstanding balance. This pattern continues with each subsequent payment, demonstrating how the interest component shrinks while the principal component grows, leading to full loan repayment.