Manage Money

What is Loan Amortization?

Amortization is the process of dividing, or rather spreading out a new or existing loan into a number of fixed payments. Such loans are paid off at the end of the designated tenure.

In this article, we’ll know more about this phenomenon.

What Exactly is Loan Amortization?

Amortization is the process which deals with how loan payments are applied in various types of loans. Generally, the monthly payments remain the same as before, and these monthly payments are divided into interest costs. By doing so, your loan balance is reduced, which is also known as paying off the loan’s principal. Doing this also reduces your other expenses like property tax.

Your final loan payment shall settle any amount which may remain on your debt account. For instance, after exactly 360 monthly payments (yes, that means 3 years), you’ll be paying off a 30-year term mortgage. To understand how loans work and how they can aid you in predicting your interest costs and outstanding balance, you need amortization tables.

How does it work?

The best and easiest way to understand the process and phenomenon of amortization is by seeing an amortization table. Anyone taking a mortgage is given an amortization table by the bank or the lender. These help you a lot. 

The table is actually a schedule which tells you how much you’ll have to pay each month in EMI, and how much of the EMI will comprise of interest and how much of principal. Regardless of which table you have, all tables contain some common items like: 

  1. Scheduled payments: The monthly payments you need to give are listed month by month individually for the whole duration of the loan.

  2. Principal repayment: In this variation, after you have paid off the interest, the remainder of your EMIs shall go for meeting your principal amount of the loan.

  3. Interest expenses: Of your monthly EMIs and expenses, a portion is given for paying off the loan’s interest. This is calculated by multiplying the remaining unpaid balance by your monthly interest rate.

While the total payment remains the same for each period, you’ll be giving the loan’s principal and interest in separate amounts per month. At the start of the loan, the interest cost is at its highest. With time, as you keep on paying EMIs per month, you’ll have to pay less and less interest each month.

Types of amortization loans

While there are various types of loans you can get, it is important to know that they don’t all work in the same way. For instance in the case of instalment loans, these are amortized and one has to pay the whole balance with level payments. These include:

Amortization doesn't work in the same way for all kinds of loans.

  1. Auto loans: These are typically for the short time, often for 5 years. You repay the loan with a fixed monthly EMI payment. You can get longer term loans, then you’ll have to give more through interest and even have the risk of your loan exceeding the auto’s resale value. 

  2. Home loans: These are over the long term, typically for 15 to 30 years. These loans do have a fixed amortization schedule, but there are also ARMs or adjustable rate mortgages. With an ARM, one can adjust the interest rate on the repayment schedule.

  3. Personal loans: These loans are available from banks, online lenders, and credit unions. These are typically amortized, and have terms of 4 years generally, along with fixed monthly payments and fixed interest rates.

Loans which don’t get amortized

There are some loans which don’t get amortized. These are: 

  1. Credit cards: These allow you to repeatedly borrow through the same card, and to choose how you’ll be repaying each month as long as you give the minimum payment.

  2. Interest-only loans: These loans do not amortize, however, that is only in the beginning of the loan’s life cycle.

  3. Balloon loans: This loan requires you to make large principal amount payments at the very end of the loan tenure. During the tenure’s early years, you make small payments.

Benefits of knowing about amortization

If you are keen to know how borrowing works, knowing amortization helps. When thinking of getting a loan, a prospective borrower seeks to know if the monthly payments are affordable or not. However, a better parameter to gauge affordability is interest costs. Lower monthly payments can mean you’ll be paying more interest, especially if you extend the loan term. For such times, amortization tables help in seeing the whole picture. A prospective borrower can thus compare different loans and repayment plans.  


Rate this article: