Before you make any decision regarding taking a loan, it is important you learn a few significant things about the types of loans and how they work. Amortized loans are a type of debt that requires regular monthly payments. You might have heard the term “Amortized” a few times in your life but chances are you do not know what it actually refers to. Even though it sounds like the name of a charming potion or something mythical, amortized loans are something really common.
What is an Amortized Loan?
An amortized loan is a type of debt that is paid off in a set time and it is also known as an installment loan. The payment is monthly and each month a portion of the payment goes towards the loan’s interest while the other part of it goes towards the principal payment.
During the early stages, the payment goes towards paying off the interest amount, and then the remaining repayments are used to pay off the principle of the loan. This means that in the starting the highest amount from the repayment goes toward the interest and the small portion goes towards principal payment but after a while, it switches. The principal balance starts increasing and the interest starts decreasing.
Most of the loans we take such as personal loans, automobile loans, mortgages, and student loans are all amortized loans that come with fixed monthly payments and fixed interest rates.
How Does Amortized Loan Work?
In an amortized loan, the total payment is divided into fixed monthly amounts that have to be repaid based on the interest rate and the loan’s term. The borrower has to pay off the interest first, which is calculated by taking the current loan balance and multiplying it by the applicable interest rate. After each payment, the interest amount is calculated again by using the current loan balance. Over time, the interest amount lessens, and the principal amount increases.
Types of Amortized Loans:
The payment schedule of an amortized loan varies on the type of amortized loan you have chosen. While the business and commercial loans have their own amortization methods, the most common types of consumer loans include:
- Full Amortization with a Fixed Rate:
This is a type of loan that will be completely paid off by the end of the predetermined amortization period. Due to the fixed interest rate, you’ll have to pay equal payments for the whole lifetime of the loan although sometimes, the final payment may be a little higher or lower depending on your remaining loan balance. Usually, mortgages and personal loans are fully amortized loans with fixed payments and interest rates.
- Full Amortization with Variable Interest Rate:
These are full amortization loans that have a variable interest rate. You will pay the same amount for time and then according to the terms, the interest rate will change. Each time the interest rate will change, the loan will be re-amortized. This means a new amortization schedule will be created. As a result, the amount you have to pay monthly may increase or decrease each time a loan’s interest rate changes.
- Full Amortization with Deferred Rate:
Some partially amortized loans require interest-only payments for the initial period of time before the payment switches to being fully amortized for the remainder of the payment term. For example, if a loan has a term of 20 years, then for the first 5 years, the client will only have to make interest payments. However, after this time period, the client will pay both the principal and the interest payments for the remaining 15 years or until the loan has been completely paid off.
- Partial Amortization with a Balloon Payment:
There are some partial amortization loans that require interest payments in the initial stages by following with a balloon payment plan. Balloon payments were quite common in the early times for consumer mortgages. Although balloon payments are usually higher and can equal up to twice the amount of an average monthly loan payment, you will have to be sure you can pay off an amount this huge before you go with this plan.
- Negative Amortization:
In this loan type, the interest rate is not included in the amount you have to pay. This unpaid interest amount is added to the total loan balance or the principal amount and your balance increases. This is also known as the capitalization of the loan. As the balance increases, you will still have an amount left to pay even after you have fully paid the principal balance. This means that you will have to pay not just the interest on the principal amount but also the interest on the interest amount.
Benefits of Amortized Loans:
Amortization loans offer the borrower a clear and set monthly time period for paying off the loan payments. The amortization loan schedules are also really handy and helpful when it comes to checking the status of your loan. You can easily determine how much amount you have to pay and how much is already paid. It will also tell you how much of your payment will go towards paying off the interest and how much will go towards the principal amount. This prevents any type of confusion that may occur due to any irregular payments. It also helps you compare loan options and choose the one best suited to your needs.
In conclusion, amortized loans are a great option as they are easier to track and you are provided clear and complete information regarding the payments you have to make each month or over the whole time period. They make the debt process easy with set monthly payments and are often termed as the modern process of breaking down a conventional loan amount into easy-to-monitor and easy-to-pay payment schedules. No matter which type of loan payment plan you choose, it is best to research it beforehand so that you can make an informed decision that will benefit your future operations.