What is an Amortized Loan?

What is an Amortized Loan?

An amortizing loan is a type of debt that requires regular monthly payments. Each month, a portion of the payment goes toward the loan’s principal and part of it goes toward interest.

Also known as an installment loan, fully amortized loans have equal monthly payments. Partially amortized loans also have payment installments, but either at the beginning or at the end of the loan, a balloon payment is made.

Over time, the balance of an amortized loan decreases. A borrower can monitor the progress of paying off his or her loan’s balance by using an amortization schedule.

An amortization schedule is also a helpful visual representation that depicts exactly how much of each month’s payment goes toward interest and how much is applied to principal reduction.

Before any regular monthly payment is applied to reducing the loan’s principal, the borrower must first pay a portion of the interest owed on the loan.

To calculate the amount of interest owed, the lender will take the current loan balance and multiple it by the applicable interest rate. Then, the lender subtracts the amount of interest owed from the monthly payment to determine how much of the payment goes toward principal.

As the balance of the loan decreases, the portion of your payment that is applied to interest payment also decreases, while the amount that pays down the loan’s principal increases.

Most types of installment loans are amortizing loans. For example, auto loans, home equity loans, personal loans, and traditional fixed-rate mortgages are all amortizing loans.

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Interest-only loans, loans with a balloon payment, and loans that permit negative amortization are not amortizing loans.

How an Amortized Loan 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.

Using Amortized Loans to Maximize Utility

For a borrower, getting an amortized loan can allow them to make a purchase or an investment for which they currently lack sufficient funds. In addition, the fact that loan payments do not vary from month to month gives the borrower predictability into their future monthly expenses. Although there is a cost to borrowing (the total amount of interest paid over the life of the loan), in many instances, the benefits outweigh the costs.

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For example, if taking out a student loan is the only way an individual can afford to attend university, then taking out such a loan is financially beneficial over the long term if their increased earning potential because of their education is higher than the cost of the loan.

If someone makes the determination that obtaining an amortized loan makes sense for their situation, there are a few considerations to keep in mind. Longer amortization periods result in smaller monthly payments but larger interest costs over the life span of the loan.

So, careful consideration of one’s circumstances must be undertaken to determine what amortization period best serves their needs and purposes. In addition, when possible, it is good practice to make lump-sum payments towards your loan, as it decreases the principal of the loan, and hence, subsequent monthly interest charges.

Amortizing loan example

Hal and Barb borrowed $100,000 to buy a condominium in a suburb of Cleveland. They got an amortizing loan with an interest rate of 5 percent.

In the first month of the loan, the part of the payment that was applied to loan principal was $120.15, while the amount applied to interest was $416.67.

By month 12, the payment portion that was going toward paying off principal was $125.78, while the amount applied to interest had fallen to $411.04.

Do you have an amortizing loan? Monitor your amortization with an amortization schedule.