An amortized loan is one that involves a payment schedule where each payment is split between both the interest and principal of the loan. Common amortized loans include mortgages, auto loans, and personal loans.
What Is an Amortized Loan?
Amortized payments provide a straightforward way to plan your loan repayment. An amortized loan is repaid in equal amounts at fixed intervals. This means that over the life of the loan, the payments remain the same. These loans make it simple to create and stick to a budget. Amortized loans are based on a schedule that works by balancing the amount of money paid through installments towards the principal and towards the interest, while ensuring that your payment remains fixed, month after month, over the life of the loan.
Repaying a fixed rate on the balance of your loan makes it much easier to stick to a budget. When opting for an amortized loan, you’ll use an amortization schedule which includes the total payment due and the breakdown of how your payments are allocated to principal and interest charges.
With every payment, a portion of the amount goes towards repaying the principal and the rest is used to bring down the interest and fees. In the beginning, it may seem like the entire payment is allocated to interest and fees — and mostly, it is. As time passes and with regular timely payments, you will see the loan’s principal balance decrease. This is how amortized loans are designed. Most often seen with mortgage loans, initial payments can be made up of over 70% interest. The portion of your payments allocated to principal and interest will vary. Thanks to the amortization schedule and knowing that your payment amount will remain the same from one month to the next, you’ll always have a clear idea where you are at and where you are headed when it comes to repaying your loan.
Here’s an example — let’s say you’ve taken out a $200,000 mortgage with a 5% interest rate. With a 30-year term, the total debt will amount to $386,512, so the monthly rate shall equal $1,073.64. The amortization table below provides an example of how amortized payments look over the entire term of the loan.
Note that minor rounding issues may occur when calculating the amortization schedule, which you should sort out with your lender. Such minor errors can sometimes result in installments of varying amounts (a few dollars higher or lower than usual).
You will notice, installment payments in the first few years comprise mostly interest charges with little applied to principal. Towards the end of the loan, you will notice just the opposite, with the larger portion of your payment allocated to the principal and very little towards interest.
Which Repayment Plan Works Best?
Even though amortized payments might be a good choice for some, also consider alternative repayment means. Unlike an amortized loan (sometimes called “straight line” or “linear” amortized loan), there are many other repayment options. Some loans use partial amortization, while other loans rely on bulk repayment.
Balloon loans include partial amortization and a final payment. That ending finance charge is usually larger than the average installment.
Bullet loans are similar to balloon loans, but they come without amortization. With bullet loans, the whole principal is repaid at the end of the term in bulk. With many bullet loans, the interest is also included in this final payment. If not done this way, then the interest is paid in installments before repaying the principal amount — which is why they are similar to balloon loans, and often used synonymously.
Consider your earnings when picking a repayment schedule. If your income is consistent for the long-term, a (linear) amortized loan could be an excellent choice. It makes planning your life much easier. If your earnings are irregular, consider the bullet loan. Especially, if you expect your income to increase as the loan term progresses.
Amortization is Easy and Convenient
To summarize, remember the key point that an amortized loan is repaid through equal installments at fixed time intervals, manageable and providing great convenience, it’s an excellent choice if your income is stable and you are out for a loan with a considerable principal amount, such as a mortgage.
And, in case you are looking to prolong the period before paying the bulk of the debt, balloon or bullet-type loans could be fantastic alternatives.
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