What is an amortized loan?
Amortized loans are loans that require scheduled, periodic payments. The payments apply to both the principal and the interest. Initial payments go towards the interest, after which the payments go towards the principal.
Simply put, installment loans are amortizing loans. For example, auto loans, personal loans, mortgage loans, and student loans are amortizing loans.
How does an amortized loan work?
The most recent ending balance decides the interest on an amortized loan. The interest reduces as more payments are made. After a certain amount for the interest is allocated, the remaining payments go towards paying off the principal. With this, the balance also decreases. With regular monthly payments, the interest gets calculated on the new outstanding balance, so the borrower pays off the interest first and the principal later.
Here’s how it works:
- Your current balance is multiplied by the interest rate applicable to the current period. This gives the current interest due.
- The interest due is subtracted from the outstanding current balance to give you the principal paid in the period.
- To get the new outstanding balance, you subtract the principal already paid in the period from the current balance.
- The outstanding balance is then used to calculate the interest for the next payment period.
This process is repeated each month until the loan is paid off.
All these details are spelled out in the amortization schedule which lets you track all your loan payments, dues, and interest rates.
What are the pros and cons of an amortized loan?
These are some of the advantages of amortized loans:
- Predictable monthly payments. Amortized loans have fixed monthly payments, which makes it easy to budget for the loan payments.
- Gradually decreasing interest payments. As you pay down the principal on an amortized loan, the interest payments decrease. This means that you will pay less interest over the life of the loan.
- Ability to pay off the loan early. Many amortized loans allow you to pay off the loan early without penalty. This can save you money on interest.
There are also some disadvantages to amortized loans:
- Higher upfront interest payments. The early payments on an amortized loan are mostly interest, with a small portion going towards the principal. This means that you will pay more interest in the early years of the loan.
- Longer repayment terms. Amortized loans typically have longer repayment terms than other types of loans, such as balloon loans. This means that you will be paying interest on the loan for a longer period of time.
How are amortized loans different from other types of loans?
Two other common types of loans similar to amortized loans are balloon loans and revolving debt.
Balloon loans are typically short-term during which only a part of the principal is amortized. At the end of the term, the remaining balance is usually large.
Revolving debt is when there isn’t a fixed amount to pay every month, unlike an installment loan. With revolving debt like a credit card, you borrow against a credit limit, and as long as you are within that limit, you can continue to borrow. Paying off all or some of the debt will let you borrow more money again because it frees up the amount of credit you have.