Jason is cash strapped and he needs an urgent loan to save his house, so he went to a bank to get a loan of $5000. He signed an agreement to pay back in two years and the bank told him he will pay back $6100 spread between 24 months equally.
He will first pay off the interest that will accrue over that period then the principal will be spread out. This is practically Amortization.
Loan amortization is a type of loan that is repaid periodically both on interest and principal. A table and calculator are used to track and calculate the fixed amount to be repaid.
Amortized loans
This is a type of loan that is spread out over some time. During this period, an equal amount of money is repaid to the lender, and from this money, a large percentage covers the principal repayment, and the smaller percentage covers the interest repayment. In order words, the money paid back by the borrower is in smaller part debt servicing and larger part principal repayment.
Amortized And Unamortized Loans
Unamortized loans are quite different from amortized loans in the sense that in unamortized loans; it is only the interest that is being repaid during the loan term, the principal is paid in once at the end of the terms. Contrary to the above explanation on amortized loans, this has a lower monthly repayment due to the interest-only is being paid, however, the principal repayment is at once and can be difficult to pay. Amortized loans pay equal payments during the loan terms and part of the repayment goes to debt servicing (interest) while the larger percentage goes to principal repayment while unamortized pay back little during the loan terms which only covers the interest, while the principal is paid back at the end of the loan terms.
Types Of Amortized Loans Vs Types Of Unamortized Loans
| S/N | AMORTIZED | UNAMORTIZED |
| 1. | Auto loans | Interest-only loans |
| 2. | Student loans | Credit cards loans |
| 3. | Home equity loans | Home equity lines of credit |
| 4. | Personal loans | Loans with balloon payments such as mortgages |
| 5. | Fixed-rate mortgages | Loans that permit negative amortization |
1. Auto loans
These are five years or shorter amortized loans that are repaid with a fixed payment per month. Longer loans are available but you run the risk of paying more than your car resale value just to get a lower payment per month.
It means that if you try to extend the months of payment so that you can pay a lesser amount per month, you run the risk of paying way higher than the amount you will be able to sell your car.
Read: Motorcycle Financing In 2022: 6 Best Loans To Access
2. Home loans
15-30 years fixed-rate mortgages, which have a fixed amortization schedule. People sell off the house or refinance the loans before the end of terms; in both cases, home loans work like an amortized loans.
You can get a home mortgage for 15years, after 5 years of repayment, sell the house when it has hugely appreciated, pay off the loans, or swap the property for another of equal value. A visit to a realtor will shed more light on mortgage loans.
3. Personal loans
Personal loans from banks, cooperative unions, online lenders are usually amortized. The repayment amount is always fixed throughout the loan schedule.
4. Credit card loans
You can borrow multiple times on the same card and choose to pay any amount back in as much as it meets the minimum amount to pay back at a time.
It is otherwise called a revolving credit in the sense that you can continue to borrow to a limit as long as repayment meets the minimum requirement and is made on time.
5. Interest-only loans
These loans don’t amortize as only the interest is paid back during the loan terms.
Extra payment made during this period will go and reduce the principal and the lender can request you start paying back the principal in installment or in full.
These loans are flexible in their repayment of the principal and this mostly lies on the condition of agreement; so do well to go through the papers very well before signing an interest-only loan.
6. Balloon Loans
These loans make you pay a large principal payment at the end of the loan. You pay little money during the early years of the loan and the bulk of the money is paid at the end.
In most cases, balloon payments are refinanced. Loan refinancing is replacing an old loan with a new one; that is the money gotten from the new loan is used to pay off the old loan and you can do well to find a new loan whose interest rate is lower than the current loan interest rate.
How loan Amortization works
Loan amortization is quite explicit, it helps borrowers to know how much they are paying back with interest, how much they will pay back monthly as well as makes them aware of the amount of outstanding they have.
There is always a table that spells out these facts.
It also helps borrowers to determine how much can be saved in interest by paying double at a particular time; that is, it can be cheaper if the borrower pays back in 6months while the loan period is 12months.
How to amortize loans
Loans can be amortized using an online calculator or excel spreadsheet. However, it can also be calculated by hand using the following formula
a/{[(1+r)n]-1} / [r(1+r)n] =p where
a = the total amount of the loan
r = interest rate per month (annual rate/ number of payments per year)
n = number of payments (number of payments per year x length of loans in years)
For example:
An amortized loan of $5000 at a 6% interest and amortized over two years will be calculated as thus:
$5000 / {[( 1+0.005)24]-1} / 0.005(1+0.005)24] = $221.60 per month
Read: USAA Career Starter Loan: Know This Before You Take Loans In 2022
What is an Amortization Table?
This is a table that lists all scheduled payments on a loan as calculated. it shows the amount of the payment that is for principal and interest monthly, the interest rate, and the loan terms. the tables consist of:
- Loan details: Values required to calculate the loan repayment are entered separately on the sheet, not into the table.
- Payment frequency: the table also shows how frequently the repayments will be made, most popularly is monthly.
- Total repayment: this shows the total monthly repayment of the borrower
- Extra payment: the borrower can pay more than the required principal in a month, in such a case, the extra payment will be deducted from the remaining balance, and interest is calculated based on the remaining principal balance.
- Principal repayment: this part shows how much of the monthly repayment goes to the principal.
- Interest costs: this column tracks the amount of the repayment that goes into servicing the loan (interest).
- Outstanding balance: shows the outstanding balance on the loans after each monthly payment. It is calculated by subtracting the amount of principal paid in each period from the current loan balance.
| MONTHS | BEGINNING BALANCE | INTEREST | PRINCIPAL | ENDING BALANCE |
| 1 | $15,000 | $75 | $589.81 | $14,410.19 |
| 2 | $14,410.19 | $72 | $592.76 | $13,817.43 |
| 3 | $13,817.43 | $69.09 | $595.72 | $13,221.71 |
| 4 | $13,221.71 | $66.11 | $598.70 | $12,623.71 |
| 5 | $12,623.7 | $63.12 | $601.69 | $12,021.32 |
| 6 | $12,021.32 | $60.11 | $604.70 | $11,416.61 |
| 7 | $11,416.61 | $57.08 | $607.70 | $10,808.89 |
| 8 | $10,808.89 | $54.04 | $610.76 | $10,198.12 |
| 9 | $10,198.12 | $50.99 | $613.82 | $9,584.30 |
| 10 | $9,584.30 | $47.92 | $616.89 | $8,967.42 |
| 11 | $8,967.42 | $44.84 | $619.97 | $8,347.44 |
| 12 | $8,347.44 | $41.74 | $623.07 | $7,724 |
| … | … | … | ,,, | ,,, |
| 24 | $661.50 | $3.31 | $661.50 | $0.00 |
Frequently asked questions on loan amortization
Loan amortization is the process of scheduling out a fixed-rate loan into equal payments. A portion of each installment covers interest and the remaining portion goes towards the loan principal.
An amortized loan is a type of loan that the borrower pays back at a scheduled rate, which the payment partly for the interest and the principal.
Auto loans, home equity loans, personal loans, traditional fixed mortgages.
Amortization is important because it helps businesses and investors understand and forecast their costs over time.
It is good, it helps you budget for large debts.
With each payment, the borrower builds equity in an asset; after the final payment, the borrower owns the asset.
It means that when you pay, you still owe more because you are not paying enough to cover the interest. The unpaid interest adds up to the amount you borrowed and the amount you owe increases.
The term of your loan, the amount of your loan, and your interest rate.
Conclusion
If you have to take a loan, Amortized loan is your best shot because the amount you owe decreases over some time and you can pay it off without being overwhelmed meanwhile unamortized loans can take a drastic turn if you don’t have huge cash available to offset the loan.
Read: What Is Super Jumbo Loan? Rate And Loan Limit
References
- FORBES: AMORTIZATION OF LOANS
- THE BALANCE: AMORTIZATION CALCULATOR
- THE BALANCE: HOW AMORTIZATION WORKS
- ZACKS FINANCE: AMORTIZED VS UNAMORTIZED LOANS
- INVESTOPEDIA: AMORTIZED LOANS
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