What Is Loan Amortization and How Does it Work?
Loan amortization is when your loan has scheduled periodic payments, usually monthly, that is applied to both the loan principal and interest. Generally, the loan payment you provide each month is first used to pay off interest, then the loan’s principal amount. Therefore, your payment may be used to pay off interest or principal in different amounts each month, but the payment amount you owe is still the same.
You usually don’t know about your loan amortization schedule because the same payment is due each month. However, you can use a table or calculate your amortization yourself using a formula to review your amortization schedule.
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Types of Amortized Loans
If you’re wondering what loan amortization is, keep in mind that most of the loans you have probably use an amortization schedule you aren’t even aware of. Any installment loan is amortized to provide you with even payments, including:
- Car loans: When you buy a car but don’t pay the full purchase price, you may need to apply for a car loan. Whether you finance your car through a dealer or through a financial institution, the loan itself will be amortized.
- Home loans: When you finance your home, you may have different types of mortgage options, all of which will be amortized. Loan amortization is used with home mortgages because it allows you to make a fixed payment to the bank each month, making it easier for you to budget.
- Personal loans: You might need to take out a personal loan for a big expense, such as a home repair, a vacation, or a new boat. When you pay off a personal loan, the periodic payments due are usually the same each month because of amortization.
A loan amortization schedule is also referred to as an amortization table. It shows you how much of your periodic loan payment contributes to the loan’s interest and how much contributes to its principal. This allows you to see how each payment you make affects the loan. In most amortization tables, you can also look at the total interest you’ve paid on the loan so far and the balance that still remains after each period.
The amortization schedule is organized by the payment period. This allows you to see how your balance is reduced after each payment and how the interest you’ve paid grows over time. You can use this table to figure out how much loan balance will be left after a specific date. The loan payment that you owe each period, however, will not change.
An amortization schedule is used to help you understand how your payment is affecting the loan. However, the table cannot be created until an amortization formula is used to calculate what your monthly payment is first. If you want to know how to calculate amortization, the formula looks like this: A=P(r(1+r)n/(1+r)n-1). In the amortization formula:
- A stands for the payment amount per period, which is what we’re trying to solve.
- P stands for the initial principal, which is your loan amount.
- r is the interest rate per period, or how much interest you’re expected to pay per month.
- n stands for the total number of payments or periods, which is your loan term.
For example, let’s say you bought a car for $20,000 and got a car loan for the entire purchase price. The loan term is five years and you’re responsible for a nominal 7.5% annual interest rate. In this example, your loan’s principal (P in the formula) is $20,000. The interest rate per period (r in the formula) is found by dividing 7.5% per year into 12 months, which equals 0.625% per period.
Since your loan term is 5 years and you’re paying monthly, you’ll be responsible for 60 pay periods (n in the formula). When you plug these numbers into the formula, you’ll find that your monthly payment (A in the formula) is $400.76.
Your loan may use a different amortization schedule, depending on the type of loan you obtained. Different amortization methods have their own benefits and drawbacks, so it’s important to understand which method is used with your specific loan before agreeing to loan terms.
With partial amortization, you only pay part of the monthly payment. This leaves you with an outstanding balance at the end of the loan term. Your monthly payments are lower with a partial amortization loan since you’re only paying the interest.
However, at the end of the loan term, you’ll owe the entire balance of the loan, so you must make what’s called a balloon payment. If you agree to a loan with partial amortization, you’ll be responsible for smaller monthly payments at each period, but be ready to pay a lump sum at the end of the loan term.
If your loan offers negative amortization, you can pay less than the interest due each month. As you can imagine, this results in very low monthly payments. However, each month that you make a low payment that’s less than the interest due, this balance is added to your principal loan amount. This type of loan allows you to make extremely small monthly payments throughout the term, but keep in mind, these payments aren’t contributing to the loan principal.
It can take a long time to pay off a negative amortization loan because the amount you owe continues to grow. The lender sets a specific date for the negative amortization to end. When it ends, payments are calculated so you can begin paying down the loan’s balance and interest.
Purpose of Loan Amortization
Loan amortization is helpful because it allows you to make one monthly payment evenly throughout the loan term. While your payment may be contributing a different amount to interest and principal each month, it makes it easier on you, the borrower, to simply provide this fixed amount.
When you have equal payments each month for your car, home, or personal loan, you can easily create a realistic budget that allows you to strive toward other financial goals. Since there are no surprises and you know exactly how much your loan payment is month to month, you can keep a better eye on your finances, including your income and expenses.
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