How Does An Amortized Loan Work?

When researching the different kinds of financing options available to you, you’ve likely stumbled across an amortized loan. Loan amortization refers to a type of lending product that includes scheduled payments that are made periodically to both the principal amount and any interest accrued. 

Keep reading to learn more about this financing option and how it works. In addition, discover if it’s right for you. 

What Does An Amortized Loan Mean?

The word amortize means to gradually write off the initial cost of an asset over a period of time. This is, in essence, how this loan type functions. 

So, what’s the loan amortization formula? First, you pay off relevant interest for a specific time period, then the remainder of the amount owed goes towards reducing the loan’s principal amount. Since any payment that exceeds the interest reduces the total you owe on the debt, the balance on which interest is calculated is further reduced. 

That means the current balance of your lending product minus the amount of principal paid during the specified period will give you the most current outstanding balance of your debt. It’s this new balance that interest for the next period is calculated upon. 

The Types Of Loans That Are Amortized

There are a variety of different lending products that can follow this process. These might include: 

• Personal loans: You can take these types of products from your bank, an online lender, or a credit union. They usually come with fixed monthly payments and interest rates. The funds can be used for a number of projects and even debt consolidation
• Home loans: If you plan on keeping your mortgage for its entire term (usually over the span of 15 to 30 years) and it’s a fixed-rate loan, it features level payments over the entire duration
• Car loans: Financing on vehicles can stretch up to seven years in some cases. Moreover, these lending products come with a fixed monthly payment 

Types Of Loans That Don't Get Amortized

Some lending products aren’t eligible to be amortized. These types include: 

• A balloon loan: This option requires the borrower to make a large payment at the end of the term
• Interest-only loans: Once the lender starts requiring you to make payments on the principal, you might be able to switch this to an amortized option. However, the beginning of this loan requires that you pay off only the interest
• Credit cards: These require a minimum payment, but in general, you can decide how much you want to pay each month. Credit cards are referred to as revolving debt, and therefore not eligible given that payments may vary based on the balance carried by the cardholder 

How Does It Work?

Are you wondering how to calculate amortization? Here are some simple steps to help clarify the process: 

1. When you begin with month one of your term, take the complete amount of the loan and multiply that by the interest rate (note that annual interest rates may be divided by 12 to find a monthly rate) 
2. Next, subtract the interest owed from the total monthly payment 
3. The remainder is what will go toward paying the principal amount of your debt 

If you have any questions about your fully amortized loan breakdown, you can always ask your lender to walk you through the process. Understanding what you owe and how your lending product works is vital to your ability to keep track of monthly payments and not fall behind on your repayments.  

Advantages Of Amortization

Understanding what loan amortization is can be critical in comprehending exactly how loans function. Many borrowers will simply see the debt amount as the total they owe. However, interest rates and other fees can add, sometimes significantly, to your overall balance.

When you’re able to look at your financing offers in an amortization table, you can judge and consider your different options more easily. Perhaps the biggest advantage is when you prepay the loan amount, reducing your overall principal total and interest simultaneously.

Bottom Line

Whether you’re looking for a personal loan, mortgage, or auto financing, it’s a good idea to see how amortization factors into your monthly installments. Understanding your financing options is crucial for reaching your financial goals while maintaining solid financial health.