An amortized loan is a loan with scheduled periodic payments that are applied to both principal and interest. An amortized loan payment first pays off the relevant interest expense for the period, after which the remainder of the payment reduces the principal. Common amortized loans include auto loans, home loans, and personal loans from a bank for small projects or debt consolidation.
Working of Amortized Loan
Interest is calculated based on the most recent ending balance of the loan and 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 amortization 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.
Amortized Loans vs. Balloon Loans vs. Revolving Debt and Credit Cards
Here’s how you can tell these three loan types apart. When you’re taking out a loan, be sure you’re getting the kind you need.
- Amortized loans are generally paid off over an extended period of time by equal amounts for each payment period. However, there is always the option to pay more and thus further reduce the principal owed.
- Balloon loans, on the other hand, typically feature a relatively short term and only a portion of the loan’s principal balance is amortized over that term. At the end of the term, the remaining balance is due as a final repayment, which is large, generally, at least double the amount of previous payments.
- Revolving debt and credit cards don’t have the same features as amortized loans since they don’t have set payment amounts or a fixed loan amount.
- An amortized loan is a loan with scheduled periodic payments that are applied to both principal and interest.
- An amortized loan payment first pays off the interest expense for the period while the remaining amount reduces the principal.
- As the interest portion of the payments for an amortization loan decreases, the principal portion increases.