What Is an Amortized Loan?
An amortized loan is a form of financing that is paid off over a set period of time. Under this type of repayment structure, the borrower makes the same payment throughout the loan term, with the first portion of the payment going toward interest and the remaining amount paid against the outstanding loan principal. More of each payment goes toward principal and less toward interest until the loan is paid off.
Loan amortization determines the minimum monthly payment, but an amortized loan does not preclude the borrower from making additional payments. Any amount paid beyond the minimum monthly debt service typically goes toward paying down the loan principal. This helps the borrower save on total interest over the life of the loan.
What Is a Fully Amortized Loan?
A fully amortized payment is one where if you make every payment according to the original schedule on your term loan, your loan will be fully paid off by the end of the term.
The term amortization is peak lending jargon that deserves a definition of its own. Amortization simply refers to the amount of principal and interest paid each month over the course of your loan term. Near the beginning of a loan, the vast majority of your payment goes toward interest.
Over the course of your loan term, the scale slowly tips the other way until at the end of the term when nearly your entire payment goes toward paying off the principal, or balance of the loan.
There are differences between the way amortization works on fixed and adjustable-rate mortgages (ARMs). On a fixed-rate mortgage, your mortgage payment stays the same throughout the life of the loan with only the mix between the amounts of principal and interest changing each month.
The only way your payment changes on a fixed-rate loan is if you have a change in your taxes or homeowner’s insurance. With an ARM, principal and interest amounts change at the end of the loan’s teaser period. Each time the principal and interest adjust, the loan is re-amortized to be paid off at the end of the term.
Types of Amortizing Loans
Amortizing loans include installment loans where the borrower pays a set amount each month and the payment goes to both interest and the outstanding loan principal. Common types of amortizing loans include:
- Auto loans
- Student loans
- Home equity loans
- Personal loans
- Fixed-rate mortgages
Amortized Loans Vs. Unamortized Loans
With an amortized loan, principal payments are spread out over the life of the loan. This means that each monthly payment the borrower makes is split between interest and the loan principal. Because the borrower is paying interest and principal during the loan term, monthly payments on an amortized loan are higher than for an unamortized loan of the same amount and interest rate.
A borrower with an unamortized loan only has to make interest payments during the loan period. In some cases, the borrower must then make a final balloon payment for the total loan principal at the end of the loan term.
For this reason, monthly payments are usually lower; however, balloon payments can be difficult to pay all at once, so it’s important to plan ahead and save for them. Alternatively, a borrower can make extra payments during the loan period, which will go toward the loan principal.
Examples of common unamortized loans include:
- Interest-only loans
- Credit cards
- Home equity lines of credit
- Loans with a balloon payment, such as a mortgage
- Loans that permit negative amortization where a monthly payment is less than the interest accrued during the same period
How Loan Amortization Works?
The interest on an amortized loan is calculated based on the most recent ending balance of the loan; the interest amount owed decreases as payments are made. This is because any payment in excess of the interest amount reduces the principal, which in turn, reduces the balance on which the interest is calculated.
As the interest portion of an amortized loan decreases, the principal portion of the payment increases. Therefore, interest and principal have an inverse relationship within the payments over the life of the amortized loan.
An amortized loan is the result of a series of calculations. First, the current balance of the loan is multiplied by the interest rate attributable to the current period to find the interest due for the period. (Annual interest rates may be divided by 12 to find a monthly rate.) Subtracting the interest due for the period from the total monthly payment results in the dollar amount of principal paid in the period.
The amount of principal paid in the period is applied to the outstanding balance of the loan. Therefore, the current balance of the loan, minus the amount of principal paid in the period, results in the new outstanding balance of the loan. This new outstanding balance is used to calculate the interest for the next period.
- An amortized loan is a type of loan that requires the borrower to make scheduled, periodic payments that are applied to both the principal and interest.
- An amortized loan payment first pays off the interest expense for the period; any remaining amount is put towards reducing the principal amount.
- As the interest portion of the payments for an amortization loan decreases, the principal portion increases.