When taking out a loan, one of the most critical choices you’ll make is which repayment structure to use. The payment method you select determines how quickly you pay down the principal balance versus interest. As a borrower, you want to fully amortize the loan to eliminate your debt efficiently.
But what exactly does “amortize” mean? And which common repayment options actually achieve amortization?
In this comprehensive guide I’ll explain in simple terms
- What it means to amortize a loan
- The 3 main payment methods for loans
- Which of these choices fully amortizes debt
- Examples of amortizing vs non-amortizing loans
- Tips for picking the best repayment structure
- Answers to frequently asked questions
Understanding loan amortization empowers you to make smart financial decisions Let’s break it down step-by-step!
What Does it Mean to Amortize a Loan?
Amortization refers to the process of paying off a loan over time through scheduled installments. An amortized loan payment first covers the interest owed, then applies any remaining amount to reduce the principal balance.
With each repayment, the interest portion shrinks while the principal portion grows. This continues until the entire loan amount plus interest is repaid in full, leaving a zero balance.
The goal of amortization is to completely eliminate the debt through regular payments over the loan term.
The 3 Main Repayment Methods for Loans
There are three primary ways lenders structure loan payments:
1. Fixed payments – The same payment amount is made each period
2. Variable payments – The payment fluctuates based on interest rate changes
3. Interest-only payments – Only interest is paid during an initial period
Next, let’s look at which of these options achieve full amortization.
Which Repayment Method Fully Amortizes a Loan?
Of these three payment structures, the method that effectively amortizes debt through regular installments is:
Fixed payments
With fixed payments, part of each payment reduces the loan balance. This gradually decreases interest costs over time. The fixed payment amount is calculated so the loan will be fully repaid by the final payment.
In contrast, variable payments and interest-only periods do NOT fully amortize because the principal balance remains unchanged. Variable payments fluctuate with rate changes but the principal stays the same. Interest-only deals require a large final payoff.
Examples of Amortizing vs Non-Amortizing Loans
- Amortizing loans: Mortgages, auto loans, student loans
- Non-amortizing loans: Lines of credit, balloon payment mortgages
For mortgages, a 30-year fixed-rate loan gets amortized through set monthly payments. But an adjustable-rate mortgage with 5 years of interest-only payments does not amortize during the interest-only period.
Tips for Picking the Best Loan Repayment Structure
Here are some tips when choosing a repayment method:
- Amortizing fixed payments create predictable budgets
- Interest-only periods work for temporary needs
- Adjustable-rate loans risks payment spikes
- Fully amortized loans build equity and save interest costs
- Review amortization schedules before committing
Evaluate your financial situation carefully and understand the implications before selecting a repayment structure.
Key Takeaways on Loan Amortization
- To amortize means paying off debt through scheduled installments
- Fixed payments that reduce the principal balance amortize loans
- Interest-only and variable payments do not fully amortize
- Fully amortizing debt saves money on interest
Frequently Asked Questions (FAQs)
Q: Why is amortization good?
A: Amortization is beneficial because it provides a pathway to completely pay off the loan over time. This allows borrowers to pay down debt through predictable, affordable payments.
Q: Do all mortgage loans amortize?
A: No. Adjustable-rate mortgages and interest-only mortgages do not amortize during periods when the payments only cover interest. But fixed-payment mortgages are fully amortizing.
Q: Can variable payments amortize?
A: Not effectively. Though the payments fluctuate, the principal typically stays the same. The balance isn’t paid down through variable payments.
Q: Does an interest-only loan amortize?
A: No, interest-only loans do not amortize at all. The payments only cover interest, not the principal, so the balance remains unchanged.
Q: What is negative amortization?
A: Negative amortization occurs when loan payments fail to cover all the interest owed. This causes the principal balance to increase over time rather than decrease.
How an Amortized Loan Works
The interest on an amortized loan is calculated based on the most recent ending balance of the loan; the interest amount owed decreases as payments are made. This is because any payment in excess of the interest amount reduces the principal, which in turn, reduces the balance on which the interest is calculated. As the interest portion of an amortized loan decreases, the principal portion of the payment increases. Therefore, interest and principal have an inverse relationship within the payments over the life of the amortized loan.
An amortized loan is the result of a series of calculations. First, the current balance of the loan is multiplied by the interest rate attributable to the current period to find the interest due for the period. (Annual interest rates may be divided by 12 to find a monthly rate.) Subtracting the interest due for the period from the total monthly payment results in the dollar amount of principal paid in the period.
The amount of principal paid in the period is applied to the outstanding balance of the loan. Therefore, the current balance of the loan, minus the amount of principal paid in the period, results in the new outstanding balance of the loan. This new outstanding balance is used to calculate the interest for the next period.
Balloon Loans
Balloon loans typically have a relatively short term, and only a portion of the loans principal balance is amortized over that term. At the end of the term, the remaining balance is due as a final repayment, which is generally large (at least double the amount of previous payments).