An amortized loan is a type of loan with scheduled, periodic payments that are applied to both the loan's principal amount and the interest accrued. An amortized loan payment first pays off the relevant interest expense for the period, after which the remainder of the payment is put toward reducing the principal amount. Common amortized loans include auto loans, home loans, and personal loans from a bank for small projects or debt consolidation.
Key Takeaways
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.
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.
Amortized Loans vs. Balloon Loans vs. Revolving Debt (Credit Cards)
While amortized loans, balloon loans, and revolving debt—specifically credit cards—are similar, they have important distinctions that consumers should be aware of before signing up for one of them.
Amortized Loans
Amortized loans are generally paid off over an extended period of time, with equal amounts paid for each payment period. However, there is always the option to pay more, and thus, further reduce the principal owed.
Balloon Loans
Balloon loans typically have a relatively short term, and only a portion of the loan's principal balance is amortized over that term. At the end of the term, the remaining balance is due as a final repayment, which is generally large (at least double the amount of previous payments).
Revolving Debt (Credit Cards)
Credit cards are the most well-known type of revolving debt. Withrevolving debt, you borrow against an established credit limit. As long as you haven't reached your credit limit, you can keep borrowing.Credit cards are different than amortized loans because they don't have set payment amounts or a fixed loan amount.
Amortized loans apply each payment to both interest and principal, initially paying more interest than principal until eventually that ratio is reversed.
The calculations of an amortized loan may be displayed in an amortization table. The table lists relevant balances and dollar amounts for each period. In the example below, each period is a row in the table. The columns include the payment date, principal portion of the payment, interest portion of the payment, total interest paid to date, and ending outstanding balance. The following table excerpt is for the first year of a 30-year mortgage in the amount of $165,000 with an annual interest rate of 4.5%
Can I Pay Off an Amortized Loan Early?
Yes. To pay off an amortized loan early, you can make payments more frequently or make principal-only payments. Since the interest is charged on the principal, making extra payments on the principal lowers the amount that can accrue interest. Check your loan agreement to see if you will be charged early payoff penalty fees before attempting this.
How Can I See How Much of my Payment Is Interest?
Most lenders will provide amortization tables that show how much of each payment is interest versus principle. You can also request this information from your lender.
Do I Pay More Interest in the Beginning of my Loan or the End?
Amortized loans typically start with payments more heavily weighted toward interest payments.
The Bottom Line
An amortized loan tackles both the projected amount of interest you'll owe and your principal simultaneously. You can make extra principal payments to lower your total loan amount if your loan allows. Try using an amortization calculator to see how much you'll pay in interest versus principal for potential loans.
An amortized loan payment first pays off the relevant interest expense for the period, after which the remainder of the payment is put toward reducing the principal amount. Common amortized loans include auto loans, home loans, and personal loans from a bank for small projects or debt consolidation.
Amortization is known as an accounting technique used to periodically reduce the book value of a loan or intangible asset across a set period. In relation to a loan, amortization concentrates on casting out loan payments over time. When applied to an asset, amortization is slightly similar to depreciation.
Example A: A business has a $10,000 software license, which it expects will come to an end in five years. Using the straight-line method, the amortization expense would be $2,000 per year for the next five years. At the end of five years, the carrying amount of the asset will be zero.
The classic example of a non amortizing loan is a credit card. A non amortizing loan can also be structured in a number of ways, but the similarity for all of them is that the majority or all of the principal sum borrowed is paid off in a lump sum at the end of the agreed term.
1. Straight-Line Amortization: This method is the most commonly used method of amortization. It involves spreading the cost of an asset evenly over its useful life.
A non-amortizing loan has no amortization schedule because the principal is paid off in a single lump sum. Non-amortizing loans are an alternative type of lending product as most standard loans involve an amortization schedule that determines the monthly principal and interest paid toward a loan each month.
To calculate amortization, first multiply your principal balance by your interest rate. Next, divide that by 12 months to know your interest fee for your current month. Finally, subtract that interest fee from your total monthly payment. What remains is how much will go toward principal for that month.
Almost all intangible assets are amortized over their useful life using the straight-line method. This means the same amount of amortization expense is recognized each year. On the other hand, there are several depreciation methods a company can choose from.
An amortized loan payment first pays off the relevant interest expense for the period, after which the remainder of the payment is put toward reducing the principal amount. Common amortized loans include auto loans, home loans, and personal loans from a bank for small projects or debt consolidation.
Example. A company, Green Co., purchases a machine for $100,000, which it expects to use for ten years. By the fourth year, the company has charged $40,000 of the asset's cost through depreciation. This portion of the machine's cost represents the amortized cost for that asset.
A mortgage loan is an example of an amortizing loan. "Amortizing" means that part of the monthly payment is used to pay interest on the loan and part is used to reduce the amount of the loan.
In the first month, $75 of the $664.03 monthly payment goes to interest. The remaining $589.03 goes toward principal. The total payment stays the same each month, while the portion going to principal increases and the portion going to interest decreases.
An example of a fully amortized loan would be a fixed-interest rate loan for 10 years. This loan would have 120 installments paid (one per month) over the lifetime of the loan. In this situation, each one of the payments made will be equal.
Similar to what obtains for the depreciation of tangible assets, there are three primary methods of amortization: the straight-line method, the accelerated method, and the units-of-production method.
The effective interest method of amortizing a bond is considered superior to the straight-line amortization method simply because it is more accurate, from period to period, than the straight-line method, under which the same amount is amortized during every period.
The loan term describes the length of time the lender is bound by the terms and conditions of the loan agreement, while the amortization period refers to the total length of time it will take you to pay off the loan. For example, a mortgage can have a loan term of 5 years and an amortization of 20 years.
Bank debt, other than revolving credit facilities, generally takes two forms: Term Loan A – This layer of debt is typically amortized evenly over 5 to 7 years. Term Loan B – This layer of debt usually involves nominal amortization (repayment) over 5 to 8 years, with a large bullet payment in the last year.
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:max_bytes(150000):strip_icc()/dotdash_Final_Amortized_Loan_Oct_2020-01-3a606fa9285943098248ac92e8d03b40.jpg "Amortized Loan: What It Is, How It Works, Loan Types, Example (1)")
