What is an Amortizing Loan?
An amortizing loan is a type of loan that requires monthly payments, with a portion of the payments each going towards the principal and interest payments. Amortization spreads out the loan repayment into multiple fixed payments over the duration of the loan.
Although the periodic payments are made in a series of fixed amounts, the majority of the payments early in the amortization schedule are used to cover interest payments. Payments made later in the amortization schedule are used to pay the principal amount. An amortizing loan is organized in a way that it completely pays off the outstanding loan balance over a period of time.
- An amortizing loan comes with fixed periodic payments that cover both the principal and interest portions of the loan.
- An amortizing loan first pays off the interest in the early stages of the loan, and the remainder of the repayments is used to reduce the outstanding principal of the loan.
- The loan allows borrowers to pay off the loan balance fully over a specified period of time.
How Loan Amortization Works
Each loan payment to the lender comprises a portion of the loan’s principal and a portion of the interest. Before any monthly payment is applied to reducing the principal amount, the borrower first pays a portion of the interest on the loan. To calculate the interest, take the current loan balance and multiply it by the applicable interest rate. The lender will then deduct the interest amount owed from the monthly periodic payment, and the remainder of the payment will go towards the payment of the principal.
As the periodic payment reduce the loan balance, the portion of the loan that goes towards interest payment also decreases. At the same time, the amount of the periodic payment that goes towards the loan’s principal payment increases. Deducting the principal amount from the outstanding loan amount results in the new outstanding loan balance. The new balance will be used to calculate the interest payment for the next repayment period.
Therefore, the portion of interest and the portion of principal amount demonstrate an inverse relationship over the duration of the loan. Common examples of amortizing loans include home equity loans, auto loans, personal loans, and fixed-rate mortgages.
Figure 1 showcases an example of an equal-amortizing loan. The principal payment for this type of loan is consistent ($1,000 each year in this example), and the interest payments decrease each period due to a lower loan balance outstanding.
Types of Amortizing Loans
Most installment loans are amortizing loans, and the borrower pays the outstanding balance of the loan using a series of fixed-amount payments that cover the interest portion and the portion of the loan’s principal. The following are the main types of amortizing loans:
1. Auto loans
An auto loan is a loan taken with the goal of purchasing a motor vehicle. It is a type of installment loan that is structured in fixed monthly repayments that are spread over a five-year period or shorter. In auto loans, the borrower agrees to pay back the principal and interest until the total loan amount is fully paid. The loans are backed by the value of the motor vehicle being purchased, and the borrower does not fully own the motor vehicle until the outstanding balance of the loan is fully paid.
An auto loan can be categorized into two forms, i.e., direct loan and indirect loan. A direct auto loan is a loan where the borrower obtains funds directly from a lender with the goal of purchasing a motor vehicle from a dealer. The borrower, in this case, is required to make monthly payments to the lender according to the agreed terms.
An indirect loan is a financial arrangement where the car dealership sells a motor vehicle to the borrower on credit terms. The dealer and the buyer enter into an installment sale contract, and the dealer sells the sale contract to a financial institution. The borrower will then pay off the loan as he/she would pay a direct loan.
2. Home loans
Home loans are fixed-rate mortgages that borrowers take to buy homes; they offer a longer maturity period than auto loans. A home loan comes with a fixed-rate interest rate, and borrowers can calculate the period they will take to pay off the principal and interest to arrive at a monthly payment. The borrower will then pay a series of fixed monthly payments throughout the term of the mortgage.
Most homeowners do not hold the mortgage for the entire 15- to 30-year period. Instead, they can refinance the loan or sell the home to pay off the outstanding balance. Most borrowers prefer fixed-rate mortgages because they can predict the pattern of their periodic payments in the future, even if there is a change in the interest rates.
3. Personal loans
Personal loans are loans that individual borrowers take from banks, credit unions, and other financial institutions. Such loans require borrowers to pay back the loan principal and interest in fixed monthly payments over a period of two to five years.
Borrowers can use personal loans for a specific purpose, such as to purchase a car or house, pay for college or vacation expenses, or settle hospital bills. Depending on the amount of credit applied, the loan may be secured or unsecured. Secured personal loans may require the borrower to provide a motor vehicle, house, or other assets as collateral.
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