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What is Loan Amortization?

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  • Last Modified Date: 23 September 2016
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Loan amortization is simply the process of a borrower paying back the borrowed money in installments and thus decreasing the outstanding loan amount, or principal. This is in contrast to a loan where the borrower pays back the full amount in one payment. The main effect of loan amortization is reduced risk for the lender, both in terms of the likelihood of repayment and the effects of interest rates.

An amortizing loan is one in which the borrower makes regular repayments. Usually, these repayments cover both a chunk of the loan amount, or principal, plus an interest payment. While the principal repayment amount is fixed, the interest repayment may not be. For example, a personal bank loan usually has a fixed interest rate, meaning the amount paid towards interest each month is the same throughout the loan period. With a mortgage, the interest rate is usually variable, meaning the repayment amount can change significantly. It's also possible to have a fixed interest rate, but different interest payment amounts. For example, in loans where each interest payment is based on the current outstanding debt, not the full loan amount, the interest payments will decrease over time.

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The main benefit of loan amortization to a lender is reduced credit risk. This is simply because if a borrower does default, the lender will already have all the money that has been repaid. This is contrast to an all-or-nothing situation, where there is a single repayment. The fact that the outstanding debt decreases during the loan period also means a lender in a fixed-rate loan faces a continually decreasing exposure to interest rate risk. This means there is less danger that she will lose out if interest rates rise, and thus isn't getting the best possible return available from lending money.

The purest form of loan amortization is where the principal repayments are split equally over the loan period. This doesn't have to be the case, though. In some cases, the actual payment amount changes from month to month. In other cases, such as many mortgages, the payment amount is the same, but the proportions of the payment that go toward repaying the balance and paying interest change. Commonly, the proportion going toward interest will be higher at the start of the loan.

The contrast to loan amortization is usually referred to as a bullet loan. This is where the full principal is repaid at the end of the loan period. The most common example of this is an interest-only mortgage.

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Discuss this Article

andee
Post 6

@myharley - The loan calculators that are available will give you a wealth of information.

Most of them are very easy to use and you can play around with them as much as you want without needing to constantly ask someone at the bank or whoever you are dealing with.

I like to look at a complete loan amortization spreadsheet to give me a good overall picture of how much interest I pay off each month.

Every month I make a mortgage payment, the amount I pay in interest decreases. If I have any extra money to pay on principal, I like to keep track of that as well.

These calculators will tell you how soon you can pay off your loan if you make extra payments. If you are also thinking about refinancing, it will give you a lot of the information you need before you even call a mortgage loan officer.

myharley
Post 5

For some reason anytime I heard someone talking about a loan amortization table, the word sounded so intimidating to me.

I thought it was something that only those who were trained in accounting or financial services would ever understand.

I didn't realize how easy it is to use the online calculators to figure out what how much your payments would be over the lifetime of the loan.

Will these calculators also tell you how soon you can pay off your loan if you make extra payments to principal along the way?

bagley79
Post 4

@animegal - I know there are several car loan amortization calculators available online, but I have always used bank rate whenever I need any kind of loan calculator.

They have many options to choose from and you can find what you need for everything from mortgage loan calculators to one for a car loan.

Having access to these calculators makes the process so much simpler in my opinion. I remember years ago, you had to rely on the professionals to give you that kind of information.

Now with just inputting a few pieces of information you can get a really good picture of how much of your payments are going to principal and how much you are paying in interest.

animegal
Post 3

Does anyone know if there are any good loan calculators available for car loan amortization?

My mom and I have been browsing for a new car and I really want to find us an affordable loan period. It seems to me that when we look at car advertisements the loans on display really need a good calculator to actually figure out what the monthly payments will be. We don't want any nasty surprises when we got to actually look at cars in person. Also, does anyone know if there are common penalties for missing a payment when you are on a amortization schedule?

letshearit
Post 2

@Sara007 - In my opinion having a shorter mortgage loan amortization period is always better because you save a small fortune in interest. Now matter how low your mortgage payment calculator may say your payments are over time, just remember the interest portion is significantly higher the longer you hold your mortgage.

In your situation you may want to see if a 25 year mortgage is right for you or work with your bank to find a shorter fixed rate mortgage. You can always shop around again when your initial rate period is over for a better interest rate. You would be surprised at how much you can save by keeping your eye on interest rates.

Sara007
Post 1

Does anyone know if it is better to get a 20 year mortgage or a 30 year mortgage?

My husband and I have been fiddling with different mortgage loan calculators with amortization settings and notice that the payments are smaller with a longer loan period. We are trying to keep our monthly mortgage payments below 25% of our income but also want to pay back our loan sooner to escape more interest payments. We're wondering if it is better to go with a longer mortgage and smaller payments or just get it done and over with sooner. We really want the best solution for our pocketbook.

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