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What Is Loan Amortization and How Does It Work?

Loan Amortization involves spreading out a loan into fixed payment periods. They are scheduled into equal payments and paid off when each period ends. This method gives borrowers a clear picture of the total amount they’ll be paying at the end of the repayment period. The set loan amount consists of both principal and interest.

What Is an Amortized Loan?

This is a type of loan subjected to a certain payment period. The borrower is required to pay the same amount over the given period. The first payment portion will cover the loan interest, with the rest going towards the principal.

During the first payment period, the amount of interest paid for the loan will be greater and decrease with each payment. On the other hand, the principal will be lower at the start and increase gradually with every payment throughout the entire loan duration.

Amortization works on different kinds of loans, including student, mortgage, and car loans.

The Difference between Amortized and Unamortized Loans

Amortized loans involved paying the same principal and interest over a given duration. This type of payment gives you an upper hand in gaining equity on assets with every payment you make.

It’s also a convenient payment method because you know exactly the amount required of you as nothing changes throughout the period. This will save you from the risk of getting into a bad credit loan and ensures you adopt better financial planning.

However, amortized loans can be quite expensive because you’ll pay interest and principal at the same time. You also don’t know the true cost of the loan and might end up paying more than you anticipated.

Unamortized loans have lower interest rates as you don’t have to pay both principal and interest. They’re affordable payments suitable for people who receive lump-sum payments. They’re more straightforward. Every month’s payment only goes towards the interest hence easier to calculate.

How Amortized Loans Work

The amortization process can be quite complicated if you’re not an expert, but the table can help you understand better. The table contains a schedule of each monthly payment as well as detailing the amount that will go to interest and that which goes to the principal.

The amount you’re going to pay every month for the loan remains the same over the payment period. However, the amount that goes to principal and interest changes with time. Interest costs are higher in the beginning and reduce as time goes by. The principal amount will be lower at the start but increase with time.

With the amortization table, borrowers Calculate and understand the interest amount they can save when they make additional payments. They can also reverse engineer the payment hence understand the amount they can afford.

Finally, the table aids in the calculation of the total interest amount paid annually to help with taxes. With the table, you can understand your pending amount and organize your finances accordingly.

If you prefer seeing numbers instead of too much reading, the amortization table can help a lot.

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