What Is Loan Amortization?
Loan amortization is the process of paying off the balance of a loan following a fixed repayment schedule over a fixed period of time. The monthly payments are equal but consist of two main components that change over time.
The first main component is the interest you owe your lender for borrowing their money. The second component is the money that goes to pay off the balance of the loan.
The latter is also referred to as paying off the principal of the loan.
Are the two components equal?
No. Initially, especially if this is a mortgage, a higher percentage of the monthly payment is the interest you owe the lender. A smaller portion is dedicated to paying off the balance. Gradually, the two portions become equal. At a certain point, the payment towards the balance of the loan becomes higher than the interest costs.
As you approach the end of the term, you will primarily repay the balance and the last payment will pay the whole principal off.
An amortization schedule is a table in which you can see all the payments for the whole period of the loan.
In the table, you can see the date when you have to make the payment, the interest, and the principal as well as the balance of the loan. Below, you can see an example table which illustrates an amortization schedule. As I already said, the monthly payment does not change over time.
Loan Amortization – Example
Let's take an example – a $100,000 mortgage with a term of 20 years and an interest rate of 5.25%
The monthly payment is $674 and will remain the same during the whole term.
In the first line, you can see that $438 of the whole amount is the interest costs while only $236 is principal. The balance after the first month is $99,764 because even though you paid $674, only $236 went to pay off the balance. As time goes by, the interest will decrease due to the increasing principal. The last line in the schedule would show you the total interest and principal paid by the borrower.
How To Prepare An Amortization Schedule
To begin with, I want to say that when people make an amortization schedule they assume that there are 12 days in a year.
Well, they count only the days on which a borrower has to make their payment. When will your first payment be? The day that follows the day on which you close the loan (when you sign all the documents) is when your account is opened. Your first payment is due one month after that.
How It Works
Usually, lenders make amortization loans when the borrower takes out a loan with a fixed term and payments, for instance a car loan or mortgage. Certainly, if you need to make yourself an amortization schedule without going to the bank, you need to know several things. The first one is the monthly installment, of course, the term of the loan and also the interest rate. If that's difficult for you, you can use online calculators.
Here you can find two online tools to help you do that – amortization-calculator.
Let's take the previous example. The parameters are:
- $100,000 loan
- 20 years
- 5.25% interest rate
- $674 monthly payment
For the first month, you need to multiply the periodic interest rate (1/12 of 5.25%) by $100,000.
The result is $438, which is the interest you owe for this month on this amount of money. Once you have the interest payment, you can easily calculate the principal payment: $674-$438. The result is $236.
If you want to proceed with the second month, you have to use the new loan balance. Subtract the amount of principal in the first month ($236) from the loan balance, which is $100,000. The result is $99,764. After that, you can follow the other steps and you will have the data for the second month. Then, you will have to use the new balance to calculate everything for the third month.
This is how you can create the whole schedule. It's that simple.
Types of Amortizing Loans
Loans can vary a lot depending on various factors – their purpose, their term, their interest and other factors. If a loan consists of regular, monthly payments then we can safely say that this is an amortization loan.
Which are the main types?
- Car loans are amortized loans. They are usually short-term (5 years or fewer) and have fixed monthly installments. Sometimes the term might be longer, but keep in mind that for smaller amounts of money it won't be justified. At the end of the period, you will see that you have paid more for interest than the principal of the loan.
- Mortgages are a typical example of amortization loans. These are home loans in which borrowers secure with the property itself. They tend to have longer terms than the other loans since the amount of money is much higher. A typical mortgage term is 20 or 25 years. In most cases, people either refinance their mortgage or sell the property, therefore it's highly unlikely to use the amortization schedule for the whole period.
- Personal loans are also amortization loans, which borrowers take out for debt consolidation, small repairs, vacations, weddings, etc. These loans have a fixed term ( 3, 4, 5 or 10 years) and a fixed interest rate.
Loans That Are Not Amortized
Some loans do not amortize. Are credit cards one of them? The short answer is yes.
If you are a credit card holder, you know that you can borrow money as long as you make the minimum payment each month. It's up to if you want to make additional payments. Credit cards do not have fixed terms and payments. Moreover, some credit cards have variable interest rates.
Another category of loans that do not amortize is the so-called interest-only loans. These loans have a set term during which borrowers need to pay only the interest portion. The payments towards the principal start at a later stage or you can do it as an additional payment. The payment is not fixed and it can change over the course of time.
A balloon loan is a yet another type that does not amortize over its term. Initially, you have to make small payments. As a result of that, at the end of the term, you will have to make a “balloon” payment to repay the whole principle.
Amortized Loans – Pros And Cons
Every coin has two sides and so do amortized loans.
The main benefits stem from the fact that amortized loans offer a clear, understandable and predictable schedule. The term of the loan is fixed, so are the monthly payments. Consequently, borrowers understand them more easily and can handle payments with relative ease. People can also track and monitor their loan using their amortization schedule.
However, there are also drawbacks.
For example, unlike other loans which give you the chance to pay only the interest or small amounts of money, amortized loans are inflexible. Initially, this could be a problem for some people because the payments might be too high. Another problem is the loan's equity, mortgages in particular. This is the amount of money that builds up over time. Unfortunately, in our case, the equity does not build up “on the front end.”
Why? Well, if you cannot make forward payments, if you keep a property just for a few years, the equity will be miserable.
In addition, experts do not recommend amortized loans for a small amount of money – let's say $3,000. Most probably, you will end up paying a lot more in interest than the actual amount of money you have borrowed.