What is a Partially Amortized Loan and How Does it Work?

A partially amortized loan is a type of loan in which only a portion of the principal is paid off over the loan term through regular periodic payments with a large lump sum payment required at the end of the term to pay off the remainder of the principal balance. This differs from a fully amortized loan where the entire principal balance is paid off over the loan term through the regular payments.

What Does “Partially Amortized” Mean?

The term “amortize” refers to spreading out loan payments over the full term of the loan. With a fully amortized loan like a 30-year mortgage, part of each monthly payment goes towards interest and part goes towards paying down the principal balance. By the time you make the final payment, the entire principal has been paid off.

With a partially amortized loan, only a portion of the principal is amortized, or paid off, over the loan term. The remaining principal balance must be paid at loan maturity through a large balloon payment

For example, let’s say you take out a 5-year partially amortized loan for $100,000. The loan is amortized over 20 years, meaning your monthly payments would be based on a 20-year amortization schedule. However, payments are only required for 5 years. After making those 60 monthly payments, there would still be a big chunk of the principal left to pay. This remaining balance would be due as a balloon payment at the end of the 5-year term.

How Does a Partially Amortized Loan Work?

Here is a simple step-by-step overview of how a partially amortized loan works

1. You take out a loan with a set principal balance, interest rate, and loan term.

2. The loan is amortized over a longer period than the actual loan term. This longer amortization results in lower monthly payments.

3. You make regular monthly payments over the loan term based on the long amortization schedule. These payments go towards interest and paying down part of the principal.

4. At the end of the loan term, there is still a remaining principal balance because the loan was only partially amortized.

5. You must make a large balloon payment to pay off the remaining principal balance and complete repayment of the loan.

The benefit of a partially amortized loan is the lower monthly payments during the loan term, making it more affordable. The main risk is being able to afford the large balloon payment at maturity.

Let’s look at an example to illustrate how a partially amortized loan works.

Partially Amortized Loan Example

Say you get a 5-year partially amortized loan for $200,000 with an interest rate of 5% amortized over 20 years.

• Principal balance: $200,000
• Interest rate: 5%
• Loan term: 5 years
• Amortization term: 20 years

Based on a 20-year amortization, your monthly payment would be $1,073.

You make monthly payments of $1,073 for 5 years (60 payments total). After 5 years, your remaining principal balance is $172,357. This is the amount you must pay as a balloon payment at the end of the term to fully pay off the loan.

With this loan, you benefit from lower monthly payments compared to a fully amortized 5-year loan. The tradeoff is you must come up with the large lump sum payment at maturity.

A partially amortized loan allows you to only pay off a portion of the principal over the loan term, deferring repayment of the remaining balance until later. This can benefit borrowers who need lower payments in the near term and are confident their financial situation will improve enough over the loan term to afford the balloon payment.

Typical Uses of Partially Amortized Loans

Partially amortized loans are most commonly used in commercial real estate lending and other types of business financing. The lower monthly payments provide flexibility in the early years of a new project or investment when cash flow is uncertain. And the business has time over the loan term to increase income and be prepared to make the large principal payment at maturity.

These types of loans may also be used by some individual borrowers for things like:

• Mortgages on investment properties
• Jumbo mortgages that exceed conforming loan limits
• Home equity loans or lines of credit
• Personal loans for major expenses like medical bills

In these situations, the borrower may qualify for the loan but need lower payments for affordability. The partially amortized structure allows this.

Borrowers should understand the risks involved before taking out one of these loans, and have a concrete plan for how they will pay off the balloon payment when it comes due.

Pros and Cons of Partially Amortized Loans

Here are some of the key pros and cons of partially amortized loans:

Pros:

• Lower monthly payments than a fully amortized loan
• Allows borrowers to only pay interest and part of principal over loan term
• Provides flexibility in early years of a new business or investment
• Interest-only payments possible in early years

Cons:

• Large lump sum payment required at end of term
• Risk of not having funds available for balloon payment
• Total interest paid likely higher than fully amortized loan
• Difficult to qualify for without strong financials
• Often requires business purpose or other special eligibility

The right loan structure depends on your unique situation. Partially amortized loans offer distinct cash flow benefits in the near term, but come with risks around the balloon payment. Evaluate both pros and cons carefully when considering these types of loans.

Partially Amortized vs Fully Amortized Loans

The main differences between partially amortized loans and fully amortized loans are:

• Amortization: Only part of the principal is amortized with partial amortization, while the full principal is amortized with a fully amortized loan.

• Payments: Partially amortized loans have lower monthly payments. Fully amortized loans have higher, fixed monthly payments that pay off all principal and interest over the loan term.

• Balloon payment: Partially amortized loans require a large lump sum balloon payment at maturity to pay off remaining principal. Fully amortized loans have no balloon payment.

• Interest paid: Partially amortized loans generally result in higher total interest paid over the full repayment period.

• Term length: Partially amortized loans often have longer stated terms with amortization schedules of 20-30 years, compared to fully amortized loan terms of 5-15 years.

The lower monthly payments of a partially amortized loan provide more flexibility, but come with the risk of a large balloon payment. Fully amortized loans provide payment certainty, but at higher monthly amounts.

Tips for Managing a Partially Amortized Loan

If you take out a partially amortized loan, here are some tips for effectively managing it:

• Understand the total interest costs over the life of the loan, not just monthly payments
• Be conservative when estimating future income and expenses
• Build up savings for the balloon payment well ahead of maturity
• Shop around for refinancing options mid-way through the loan term
• Explore making extra principal payments if possible to reduce the balloon amount
• Have a backup plan in case you can’t refinance or afford the full balloon payment
• Stay in close contact with your lender as the maturity date approaches

With proper planning and discipline, a partially amortized loan can be a viable option for certain borrowers. But it’s critical to go in with eyes wide open about the risks and mitigation strategies.

Common Questions about Partially Amortized Loans

Here are answers to some common questions about partially amortized loans:

What happens if I can’t pay the balloon payment?

If you can’t afford the balloon payment, you face default and potential foreclosure or other consequences. That’s why it’s critical to prepare for this payment. Refinancing is an option, but not guaranteed.

Can I pay off a partially amortized loan early?

Yes, most lenders allow prepaying a partially amortized loan early without penalty. This allows you to pay it off before the balloon payment comes due.

Do partially amortized loans have higher interest rates?

Sometimes, but not always. Since they carry more risk for lenders, interest rates may be 0.5 – 1% higher than a fully amortized loan. But other factors like your finances also determine rates.

How do I know if I can afford the balloon payment?

Consider your current savings, expected future income and expenses, and the total balloon payment amount. Factor in costs of living, other debts, and savings goals. Be very conservative in your estimates.

Are partially amortized loans riskier?

Yes, the balloon payment requirement does make these loans riskier overall. It’s