What Is Loan Amortization and How it Works?
Amortization is the process of distributing your loan into several fixed installments over a set period of time. It focuses on the application of loan payments to particular types of loans. Usually, the monthly payment stays the same and is split between interest charges (the amount your lender receives for the loan) and decreasing your loan principal (paying off the main loan balance), and additional expenditures such as property taxes.
Early in the loan, a greater percentage of the monthly payment goes toward paying off the interest. As you continue to make payments, a higher percentage will be used to pay off the loan principal. With amortization, you’ll have a better understanding of how a loan works and what your interest amount or the outstanding balance will be like at any point in the future.
How Amortization Works
You can use the latest financial calculators, spreadsheet applications such as Microsoft Excel, or online amortization charts to calculate your loan amortization. The amortization table, also known as the amortization schedule, can help you understand how it works.
The amortization table includes a plan for each monthly loan payment (scheduled payments) and how much of it goes to paying interest (interest payments) and principal (principal payment). The interest payment is calculated by dividing the product of the interest rate and the outstanding loan balance by 12.
Interest Payment = (Interest Rate * Outstanding Loan Balance) / 12
The amount remaining after interest payment has been subtracted from the total monthly payment is the principal payable for the given month.
Principal Payment = Total monthly payment-Interest Payment
The outstanding balance in the following month is calculated by deducting the most recent principal payment from the previous month’s outstanding balance. The interest payment is again calculated from the new outstanding balance. This pattern repeats until all the principal payments are cleared, and the loan balance is zero at the end of the loan term.
Types of Amortized Loans
Amortization of loans is a good strategy, but it is not applicable to all types of loans available today as not all of them work in the same manner. Loans with fixed monthly payments (also referred to as installment loans) are amortized where you pay off the balance in level payments over time till it’s zero. Examples of amortized loans are:
Home loans have a fixed amortization schedule as they are usually 15- to 30-year fixed-rate mortgages. However, there are adjustable-rate mortgages (ARMs) as well, in which the lenders can change the rate on a preplanned schedule and thus alter your amortization schedule. Also, 15 or 30 years is a long time. Most people don’t hold onto the same home loan for that long - they either sell the house or refinance home loan - but these loans work the same as keeping them for the entire term.
Auto loans are 5-years (or shorter) loans paid off by monthly fixed payments, thus are amortized loans.
Personal loans typically have 3-year terms, fixed interest rates, and fixed monthly payments, making them amortized loans. Banks, credit unions, or online lenders provide such loans, which are more frequently employed for personal projects or debt consolidation.
Loans that Don’t Get Amortized
As mentioned earlier, not all loans get amortized. Some examples of such loans are:
Provided that you meet the minimum payment, you can repeatedly borrow from the same card and choose how much to repay each month in this type of loan.
These loans entail a large payment at the end of the loan term, making it unsuitable for amortizing.
During the interest-only period, your payment will go towards paying off the interest, and only additional voluntary payments will go towards paying the principal. So, amortization is not applicable to such loans, at least not in the beginning. After a while, your lender will either set up an amortization schedule for you to start paying down principal and interest or ask you to pay the loan in full.
Benefits of Amortization
You can better understand how borrowing works with amortization. Interest cost is a more effective measure of assessing the actual cost of what you buy than affordable monthly payments that most people rely on. In fact, lower monthly payments can often entail larger interest payments. If you extend the repayment period, the interest you pay will be more than you would for a shorter repayment time.
The information provided in an amortization table allows you to quickly evaluate different loan options and calculate the amount you can save by paying off debts early. Comparing lenders, choosing between 15- or 30-year loans, or deciding whether to refinance an existing loan would be a little easier. However, always ask your lender if any additional information such as fees, closing costs, etc., is missing from your amortization table as sometimes these details are not included in a standard amortization table.
Need more financial advice? Contact one of our Nepali mortgage brokers at Capkon for more financial advice tailored to your specific situation.