Understanding Credit Card Amortization

Amortization is just a way of saying that a debt is being paid off over a period of time. The big impact comes from the how the debt is paid off, quickly or slowly, and how high the interest rate is. Careful choices can help erase a debt in a much shorter time and cost a lot less in the process.

Amortization With Simple Interest

The big difference between a mortgage and a credit card debt is the way the interest is calculated. A mortgage payoff is calculated using simple interest, meaning that the interest is charged only on the principal balance due. As an example, if you owe $50,000 with an interest rate of 5% and your mortgage payment is $395.40 per month for fifteen years, your first payment is applied $208.33 to interest ($50,000 times 5% annual interest divided by 12 months) and $187.07 to principal ($395.40 minus $208.33).

When you make the second payment, your principal balance is now $49,812.93 ($50,000 minus $187.07), so your second payment is applied $207.55 to interest ($49,812.93 times 5% annual interest divided by 12 months) and $187.85 to principal ($395.40 minus $207.55). Each month as you make your payment, the principal balance goes down slightly and more of your payment applies to the principal until eventually the principal balance reaches zero.

Credit Card Amortization Including Compound Interest

When you have a credit card debt, the interest is compounded, meaning it is calculated on the total amount due, including any interest charges that have been added in prior months. If you carry the debt for a long time, you end up paying interest on interest on interest, which can add up to big numbers.

Take an example of a credit card balance of $2,000 on a card with an interest rate of 10%. A typical minimum payment on a credit card is 4% of the balance, which would mean a payment of approximately $80 per month. At the end of the first month, your interest is calculated as $16.67 ($2,000 times 10% annual interest divided by 12 months).

Add the $16.67 interest to the beginning amount due of $2,000 for a total of $2,016.67. Your credit card statement will show a minimum payment due of $80.67 (4% of $2,016.67). If you make that minimum payment, your next statement will show a balance due of $1,936 ($2,016.67 minus $80.67) and the interest will be $16.13 ($1,936 times 10% annual interest divided by 12 months).