What is an Amortized Loan?
An amortized loan is one where the principal of the loan is paid down according to an amortization schedule, typically through equal monthly installments. A portion of each loan payment will go towards the principal of the loan, and the remainder will go towards interest charges.
Amortization periods can vary in length, with short amortization periods resulting in less interest being paid over time, and longer amortization periods providing the opposite effect – more interest being paid over time.
Monthly loan payments do not vary from month to month; the math simply works out the ratio of debt and principal payments each month until the entire debt is paid off. Examples of typically amortized loans include mortgages, car loans, and student loans.
- With amortized loans, the principal of the loan is paid down gradually, typically through equal monthly installments.
- A portion of each monthly payment goes towards interest and represents the cost of borrowing.
- The longer the amortization period, the more interest the borrower is going to pay, and therefore, the higher the cost of borrowing.
Terms to Understand
In order to understand what an amortized loan is, there are some key financial terms to understand first.
Principal: The principal is the original sum of money borrowed in a loan arrangement. It is the sum that needs to be paid back, excluding any accrued interest.
Interest: Interest is the amount charged on top of the principal by a lender to the borrower for the use of assets; it is the cost of borrowing to the borrower.
Amortization Period: It is the total length of time it takes to pay off a loan – usually months or years.
How Amortized Loans Work
At the beginning of the loan period, interest costs are at their highest. It is because the interest rate paid during each payment is the current loan balance multiplied by the interest rate; therefore, the higher the loan balance, the higher the interest rate.
Interest Rate Paid = Current Balance * Interest Rate
To illustrate the concept, let us look at an example of an individual who takes out a $250,000 loan to purchase a home at a 3.85% interest rate over a 15-year term. The table below shows how much interest they will be paying each month during the first four months of the loan.
As you can see, a large portion of each payment goes towards interest payments each month (although the amount that goes towards interest decreases every month as the balance decreases).
Towards the end of the loan period, more and more of each payment starts going towards paying down the principal:
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.
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.
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