Amortized Loan

Amortized Loan: Meaning & How Does It Work?

July 08, 2023 • 7240 views

Understanding the intricacies of the various available loan types and lending options is important to make an informed financial decision. Amortized loans are one such lending that offers a predictable repayment structure and long-term feasibility. This article will help you understand what an amortization loan is and how it works so that you can navigate the borrowing landscape with confidence.

What is an Amortization Loan?

Unlike most loan structures where the borrower focuses on typically paying the interest first and the principal is gradually reduced, an amortized loan is repaid through regular installments consisting of both principal and interest payments. In the case of loan amortization, a structured payment schedule is followed that allows borrowers to regularly reduce their outstanding debt over time. These payments are typically made monthly and in equal amounts throughout the loan term.
When each payment is made, a portion goes towards covering the interest charges for the period, and the remainder is applied to lowering the principal amount. While the interest portion is higher at the beginning of the payment schedule, a larger portion gets directed to the principal as the loan matures. The predictability offered by loan amortization helps the borrower plan their present and future monthly expenses better. Now that the amortization loan definition is clear, look at how this process works.

How Does Amortization Loan Work?

An amortized loan uses an amortization schedule for repayment. This schedule typically depends upon multiple factors such as the interest rate, the principal amount, the loan tenure, and the agreed nature of compounding between the borrower and the lender.
For example, if you have taken a Personal Loan of Rs.10 Lakh for a period of 5 years at an annual interest rate of 12%, your monthly instalment would be around Rs.25,145. In the case of an amortized loan, at a 12% interest rate, approximately Rs.15,000 would be calculated as the interest while the remaining Rs.10,145.  shall go towards reducing the principal amount. As you go closer to the loan maturity period, the allocation of payment towards the interest reduces while the payment towards the principal amount increases. Thus, in loan amortization, the interest and the principal have an inverse relationship within the payment structure over the tenure of the loan.

Importance of Amortization Loan

An amortized loan can be one of the best options if you want to budget your finances in a structured manner and avoid surprises. The structure and predictability of loan amortization allow borrowers to align their financial goals and aspirations with a clear roadmap. The following are some of the benefits of amortized loans:

  • Structured and clear payment allocation
  • Systematic debt reduction
  • Builds credit history.
  • Helps in better financial planning and goal setting.

Different Types of Amortization Loan

There are different types of amortized loans designed to meet specific borrowing needs. Several notable examples are as follows:

  • Fixed-rate Amortization Loan

This is the most traditional and popular type of amortized loan where the interest rate remains constant throughout the loan term. The stability offered by this type of loan makes it easier for borrowers to budget and plan their loan repayment.

  • Adjustable-rate Amortization Loan

As the name suggests, this type of loan has interest rates that can change periodically based on market conditions. These loans typically have an initial fixed rate after which the interest rate gets adjusted, and the monthly installment may change.

  • Balloon Amortization Loan

In this type of loan, borrowers make regular monthly payments for a specific term, usually 5 to 7 years. However, the remaining balance becomes due as a lump sum payment at the end of the term. Balloon loans often have lower interest rates during the initial period, but borrowers must plan for the large final payment. Some borrowers may refinance or sell the property to cover the balloon payment.

Some Amortization Loan Examples

  • Mortgage Loans: When individuals purchase a home, they often opt for a mortgage loan. These loans are typically long-term (e.g., 15 or 30 years) and have fixed or adjustable interest rates. Borrowers make monthly payments that include both principal and interest until the loan is fully repaid.
  • Auto Loans: Many people finance their car purchases through auto loans. These loans can have varying terms, typically ranging from 3 to 7 years. Monthly payments are made to gradually repay the loan amount, including interest charges. Auto loans are often secured by the vehicle itself, allowing lenders to repossess the car if the borrower defaults.
  • Personal Loan: You can use a Personal Loan for debt consolidation, home improvements, and other personal expenses. The loan term usually lasts from 1 year to 5 years for such loans.
  • Business Loans: Entrepreneurs and small business owners often rely on Business Loan to fund their ventures. These loans can have different structures, including amortization schedules. Monthly payments are made to gradually repay the principal and interest over the agreed loan term. Business loans can be used for various purposes, such as expansion, equipment purchase, or working capital.

These examples illustrate the versatility of amortization loans, as they can be tailored to suit the specific needs of borrowers in various financial situations.

Steps to Calculate Amortization Loan

In addition to calculating your monthly instalment, you also need to figure out the interest allocation and the remaining principal balance over the loan term when taking an amortized loan. Here is a step-by-step breakdown of how to calculate a fully amortized loan:
1.    Gather Necessary Loan Information
You will have to be clear about the principal amount, the interest rate on your loan, and the loan term to accurately calculate an amortized loan. The loan term is usually expressed in months or years, and you need to convert this term into the corresponding number of payment periods to facilitate calculations.
2.    Calculate the Monthly Instalment
After determining the monthly interest rate, you can use the amortization formula or an online calculator to calculate your monthly payment amount. The subsequent equation can be employed to calculate the same:
Monthly payment = Principal amount * (1 + Interest rate) ^Term of loan / ((1 + Interest rate) ^Term of loan - 1)
3.    Create an Amortization Schedule
You need to create a loan amortization table to track how your loan will be repaid over time. This will include your monthly instalment amount, how much of it will be allocated to interest payment and principal payment, and the remaining loan amount.
4.    Monitor Your Payment Trends and Impact on Loan Amortization
Whether to make extra payments or refinance your loans, this information in your amortization table will help you make informed decisions about your finances.

Tips for Effective Loan amortization

To make the most of loan amortization and minimise costs, consider the following strategies:

  • Making Extra Payments

One way to accelerate debt reduction is by making extra payments towards the principal balance. This not only reduces the total interest paid but also shortens the loan term.

  • Refinancing Options

Another strategy is exploring refinancing opportunities. If interest rates have dropped since you initially took out the loan or your creditworthiness has improved, refinancing can lead to lower monthly payments or a shorter loan term.

Also Read: Boosting Operational Efficiency with Working Capital Finance

Loan amortization vs. Other Repayment Methods

In comparison to other repayment methods, loan amortization offers distinct advantages:

  • Compared to Interest-Only Loans

Loan amortization stands in contrast to interest-only loans, where borrowers only pay interest during the initial period. While interest-only loans offer lower initial payments, they don't contribute to principal reduction.

  • Contrast with Principal-Only Payments

Principal-only payments are rare but can be a useful strategy for borrowers looking to aggressively reduce their debt. By exclusively paying down the principal, borrowers can eliminate the interest component and shorten the loan term.

Conclusion

An amortized loan enables borrowers to systematically reduce their debt over time. With each payment made, borrowers make progress towards full repayment, while also managing the consequent interest costs effectively. It allows individuals to make informed decisions to achieve their goals while maintaining financial stability. Whether it is a Personal or Business Loan, loan amortization provides a reliable and transparent framework to help borrowers navigate through their repayment journey.

Frequently Asked Questions

1.    What is the difference between a loan and an amortized loan?
For most loans, the borrowed amount of money needs to be repaid over a specified period of time, typically with interest. An amortized loan is a type of loan that provides a systematic approach to repayment that is structured in equal instalments, consisting of both principal and interest.
2.    What is interest vs amortized loan?
In financial terms, interest refers to the cost of borrowing, calculated as a percentage of the loan amount. An amortized loan is a type of loan that follows a structured payment schedule. Your monthly instalment in loan amortization is allocated to both principal and interest payments.
3.    Are fixed-interest rate loans amortized?
A fixed loan usually refers to a loan with a fixed interest rate and a predetermined repayment schedule. In the case of a fixed-rate amortized loan, a regular payment structure is followed that allows gradual debt reduction over time.

Disclaimer

We take utmost care to provide information based on internal data and reliable sources. However, this article and associated web pages provide generic information for reference purposes only. Readers must make an informed decision by reviewing the products offered and the terms and conditions. Loan disbursal is at the sole discretion of Poonawalla Fincorp.
*Terms and Conditions apply

poonawalla fincorp team

Poonawalla Fincorp Team

Our team of expert writers and editors are passionate about providing authentic and valuable information on finance. Our aim is to simplify financial and finance-related concepts. We strive to help our readers become more aware and empowered to make informed financial decisions.

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