Amortization Schedules of Mortgage.

Recently, Tina and I,  became home owners, and one of the experiences in that journey was the act of taking on debt. It was the second largest financial contract I have ever entered into. The first being my employment contract. When I was trying to figure out how the interest rates advertised were converted into my monthly payments, I realized that I really had no clue. Its three years now, and I think I finally get it.

Thanks to Prof. Schiller and Prof Andrew Lo, I believe I understand the concept of amortization. Their courses are available here:


YouTube: Financial Markets (2011) with Robert Shiller
Finance Theory I: Prof Andrew Lo

One of the aspects of the amortization schedule led me to the impression that the contract was in favor of the banks. Now in all reality, all contracts will typically favor the lender, but this specific aspect that bothered me was the fact that monthly payments in the early days of repayment almost entirely go towards interest payments. And I wondered to myself if this is a somewhat arbitrary decision of the banks. Was it unfair?

Now I see that the interest I was paying was simply the pro-rated interest that I owed on my outstanding loan till that point in time.
Lets say, I borrowed 100 USD @ 10% APR.  So at the end of month 1, I owed to my creditors.

Interest  = Principle * (Interest_APR/12) = 100 * (5%/12) = 0.4167 USD.

But lets say I had 5 dollars of available cash to repay.The bank takes the interest owed to them (0.4167 USD) and leaves me with 5 - 0.4167 = 4.5833 to repay my principal amount. Next month, I would be paying interest only on the the amount outstanding. Sounds fair enough to me.