Usually, a borrower makes a monthly payment to the lender when he/she takes out a mortgage, an auto loan, or a personal loan. Part of the payment is the interest charged on the loan, and the balance of the payment is to reduce the principal amount due. Interest is calculated on the current balance payable and will gradually decrease as the principal amount decreases.
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What is an Amortization?
Amortization refers to an accounting method used to gradually reduce the book value of a Loan or Intangible asset over a given period of time. When applied to a loan, amortization focuses on spreading loan payment over time. On the other hand, in relation to intangible assets, amortization is much like depreciation. This schedule is very valuable for accurately tracking the principal and interest aspects of the payment of the loan. This can be seen in effect on the amortization table.
How does it work?
Loan amortization is a process that includes paying the balance of a loan following a fixed repayment schedule over a fixed period of time. Payment of loan comprises a portion of the loan’s principal and a portion of interest. Interest is calculated by multiplying the current loan balance by the applicable interest rate. The lender will then deduct the interest amount owed from the monthly periodic payment, and the remaining payment will go towards the payment of the principal. As the periodic payment reduces the loan balance, the portion of the loan that goes towards interest payment decreases. At the same time, the amount of periodic payment that goes towards the loan’s payment increases. The new outstanding loan balance is then resulted by deducting the principal amount from the outstanding loan. The new loan balance will be used to calculate interest payments for the next repayment period.
An amortization schedule is a table that shows all the payments for the whole period of the loan. The table shows the date on which one has to make the payment, the interest, the principal, and the balance of the loan. An example of an amortization schedule is mentioned below:
Loan amount: $10000
Fixed payment each year: $1000
Interest rate: 2%
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Examples of Amortizing Loans:
Common examples of amortizing loans are:
- Personal loans: Personal loans are also a form of amortized loans that borrowers consider taking out for debt restructuring, holidays, weddings, etc.
- Fixed-rate mortgages: They are a common example of amortization loans. These are home loans in which borrowers acquire the properties for themselves and, because the sum of money is much higher, they tend to have longer terms than the other mortgages.
- Auto Loans: Generally, they are short-term (5 or fewer years) and have fixed monthly installments. The term will sometimes be longer, but it would not be taken into consideration for a small sum of money. The borrowers end up paying more interest than the principal of the loan at the end of the term.
Loans that are not amortized:
- Credit cards: There are no fixed terms and fees on credit cards and, in addition, some credit cards have varying interest rates.
- Interest-only loans: Such loans have a fixed term, whereby borrowers only pay for the portion of their interest, and payments to the principal begin afterward.
- Balloon loan: The borrower must initially pay a small payment and then make a “balloon” payment to repay the whole principal at the end of the loan period.
Benefits of Amortized Loans:
- Manageable repayment schedule as principal and interest are spread out over the long term. Tracking and monitoring of loan is easy using an amortization schedule
- Since amortized mortgages enable both principal and interest to be paid out simultaneously, each repayment gives the borrower equity in the assets, such as a house or car.
- With payments not changing month after month, it encourages and enhances efficiency in financial planning.
Drawbacks of Amortized Loans:
- The monthly payments will be very high since both the principal and the interest would be paid by the borrowers.
- Another concern with amortized loans is that the real cost of the loan is not understood by many borrowers.
In making any borrowing decisions, determining how much one will pay each month and the total interest to be repaid is essential. These details will help in assessing if the loan’s cost is really worth the requirements.
Author: Hetvi Shah
About the Author: Hetvi is a BBA(Finance) graduate. She is currently pursuing an MBA with Finance specialization. She has a keen interest in Financial Market, Financial Management, and Financial Analysis.