Loan Amortization: How Payments Split Between Interest and Principal
A $100,000 business loan at 8% interest costs $25,046 per year for five years. The payment stays the same every period, but the split between interest and principal does not. In Year 1, $8,000 goes to interest and $17,046 reduces the balance. By Year 5, only $1,855 covers interest and the rest clears the loan. Loan amortization tracks how each fixed payment divides between the two.
Key takeaway: An amortized loan has equal payments, but each one shifts from mostly interest at the start to mostly principal at the end. The annuity formula sets the payment amount, and the amortization schedule shows where every dollar goes.
The Loan
Here is a five-year term loan for a small business:
| Amount | |
|---|---|
| Principal | $100,000 |
| Annual Interest Rate | 8% |
| Term | 5 years |
| Payment Frequency | Annual |
The fixed annual payment comes from the annuity formula:
Payment = Principal x r / (1 - (1 + r)^-n)
- Principal: The original amount borrowed.
- r: The interest rate per period.
- n: The total number of payments.
The loan amount equals the present value of all future payments discounted at the interest rate. Solving that equation for the payment gives the formula above.
Applied to this loan:
Payment = $100,000 x 0.08 / (1 - 1.08^-5)
Payment = $8,000 / (1 - 0.6806)
Payment = $8,000 / 0.3194
Payment = $25,046
The borrower pays $25,046 at the end of each year for five years. The same formula works for monthly loans: divide the annual rate by 12 and multiply the term in years by 12 to get the number of payments.
The Amortization Schedule
Each payment covers the interest owed on the current balance first. Whatever remains goes to principal. As the balance drops, less interest accrues the next period, so more of the same fixed payment flows to principal.
Year 1:
Interest = $100,000 x 0.08 = $8,000
Principal = $25,046 - $8,000 = $17,046
Remaining Balance = $100,000 - $17,046 = $82,954
Repeating this for each year gives the full schedule:
| Year | Beginning Balance | Interest | Principal | Payment | Ending Balance |
|---|---|---|---|---|---|
| 1 | $100,000 | $8,000 | $17,046 | $25,046 | $82,954 |
| 2 | $82,954 | $6,636 | $18,410 | $25,046 | $64,544 |
| 3 | $64,544 | $5,164 | $19,882 | $25,046 | $44,662 |
| 4 | $44,662 | $3,573 | $21,473 | $25,046 | $23,189 |
| 5 | $23,189 | $1,855 | $23,189 | $25,044 | $0 |
| Total | $25,228 | $100,000 | $125,228 |
The final payment is $25,044 instead of $25,046 because rounding adjustments accumulate over five periods. Lenders handle this by adjusting the last payment to close the balance exactly.
Total interest over the life of the loan: $25,228. That is the cost of borrowing $100,000 at 8% for five years.
Early Payments vs. Late Payments
In Year 1, interest takes 32% of the payment. By Year 5, it drops to 7%.
| Year | Interest Share | Principal Share |
|---|---|---|
| 1 | 32% | 68% |
| 2 | 26% | 74% |
| 3 | 21% | 79% |
| 4 | 14% | 86% |
| 5 | 7% | 93% |
The shift happens because interest is calculated on the remaining balance. As principal payments reduce that balance, less interest accrues each period, and a larger share of the fixed payment goes to principal. The principal portion grows with every payment.
This is why prepaying principal early in a loan's life saves more interest than prepaying later. A $10,000 prepayment in Year 1 reduces the balance that accrues interest for all four remaining years. The same prepayment in Year 4 only eliminates one year of interest charges.
How Rate and Term Affect Total Interest
The interest rate and the loan term both change the total cost of borrowing. Here is the same $100,000 loan under four scenarios:
| Scenario | Rate | Term | Annual Payment | Total Interest |
|---|---|---|---|---|
| Base case | 8% | 5 years | $25,046 | $25,228 |
| Lower rate | 6% | 5 years | $23,740 | $18,700 |
| Longer term | 8% | 10 years | $14,903 | $49,030 |
| Both | 6% | 10 years | $13,587 | $35,870 |
Dropping the rate from 8% to 6% saves $6,500 in interest over five years. Extending the term from 5 to 10 years drops the annual payment by $10,000, but total interest jumps from $25,228 to $49,030.
A 6% rate over 10 years still costs more in total interest ($35,870) than an 8% rate over 5 years ($25,228). The longer the balance stays outstanding, the more interest accumulates, even at a lower rate.
Why Loan Amortization Matters
Amortization applies across several areas of corporate finance:
- Debt modeling: Companies with term loans need the amortization schedule to project future interest expense, principal repayment, and remaining debt balances for their financial models.
- Free cash flow: Interest payments flow through the income statement, and principal repayments reduce debt on the balance sheet. Both affect how much cash the business generates for equity holders.
- Coverage ratios: Lenders evaluate borrowers using metrics like EBIT divided by debt service. The amortization schedule provides the debt service figure: interest plus scheduled principal.
- Tax deductions: The interest portion of each payment is tax-deductible. The amortization schedule provides the deductible amount in each period, which shrinks over time.
Conclusion
Amortization divides a fixed loan payment into interest and principal, with the split between the two shifting over time. The annuity formula sets the payment amount, and the amortization schedule shows how each dollar is allocated. Rate and term together determine the total cost of borrowing.
For the present value math behind the annuity formula, see our guide on time value of money. For how debt payments factor into cash flow analysis, see our guide on free cash flow. For pricing bonds (the non-amortizing counterpart), see our guide on bond valuation.
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