How Loan Amortization Can Help You Pay Your Debt in One Simple Plan
Getting a loan usually comes coupled with a mix of emotions — happiness that your application was approved, excitement for the purpose behind the loan, and honestly, a bit of concern about paying it all back.
Whether it’s for personal or business purchases, a loan can be daunting. It’s a commitment to pay back the borrowed amount of money and any interest accrued over a certain period of time.
One way to help lighten the load is through loan amortization. Amortization of loans works by breaking up an entire loan repayment into several installments that are paid over a period of time. (Not to be confused with amortization of assets, which also allocates costs, but is generally reserved for business accounting and valuation purposes.)
In this post, we’ll go over all aspects of loan amortization, how it works, and how to calculate your own amortization table. Even if you’re one to shy away from numbers, knowing how to pay back loans in the way that’s most favorable to you is definitely something worth learning.
What Is Loan Amortization?
Loan amortization starts out like any other loan. It takes the full repayment amount and divides it into smaller installments to be paid throughout the duration of the loan, usually on a monthly basis. Common examples of loans that can be amortized include home loans, auto loans, student loans, and other personal loans. (Note that credit cards are not amortizing loans, as they allow you to borrow a number of times and choose how much you will repay each month.)
What makes loan amortization unique, however, is that it factors both the principal (the amount loaned) and the interest (a percentage of the principal) into the repayment plan. Unamortized loans often separate the payments, usually with the interest being paid first and the principal saved for last.
With amortized loans, the two numbers are figured into one total repayment sum, which is then divided into installments of equal amounts. This combined repayment plan allows you to slowly gain equity in the asset, as opposed to all your initial payments simply going toward interest.
Furthermore, because all payments are the same amount and set according to a fixed schedule, loan amortization provides a clear and simple plan for borrowers to pay back loans and plan their finances.
How Loan Amortization Works
Amortized loans differ from most other loans in that they combine both the principal and interest in every payment. Although every payment amount remains the same, the specific principal-to-interest ratio changes over time — a greater portion of the initial payments is applied to the interest, while a greater portion of the ending payments is applied to the principal.
So while you’re still pretty much paying off the interest first, this will eventually decrease and more of your payments will start going toward the principal over time. This is the nature of amortized loans — where the amounts paid for interest and principal have an inverse relationship throughout the entire loan lifespan. Amortization calculates the best ratio for each monthly payment in order to pay off the entire amount owed.
You should also check with your creditor to see if it’s possible to make any extra payments throughout the duration of the loan. Adding to the required amount whenever you can is a good way to reduce the principal and pay off the total loan faster.
Calculating for Loan Amortization
Amortizing a loan — and figuring out the required repayments — is done using a process of calculations. The three numbers you will need are the loan or principal amount, the interest rate, and the loan term or duration. Say, for example, you have taken a loan of $50,000 at a 6% interest rate. Your loan term is one year with repayments to be made monthly.
The first step is to calculate the principal payment for every month. This is done using the equated monthly installment (EMI) formula, which is EMI = [P x R x (1+R)^N]÷[(1+R)^N–1]. Don’t worry, there are many online calculators to use for this step.
Here, P is the total principal ($50,000), R is the annual interest rate divided per month (0.06 divided by 12, which is 0.005), and N is the number of payments or monthly installments (12 for one year). In our case, this equals to $4,303.32, which is the initial monthly principal payment without deducting interest yet.
The second step is to figure out the interest payment for every month. This is done by dividing the annual interest rate by 12, which is the monthly interest rate, and then multiplying this by the total principal amount. The monthly interest rate in our example is 0.005, which multiplied by $50,000, makes our monthly interest $250.
Next, subtract the monthly interest from the monthly principal. In our example, this is $4,303.32 – 250 = $4,053.32. This is the actual principal paid in the first month, added to the monthly interest paid of $250 (for the total payment of $4,303.32 for month one.)
After the first payment, your recalculated principal balance amounts to $45,946.68. Using the same formulas above, your second month’s interest now equals to $229.73. When you subtract this interest from the initial monthly principal, your payment is now divided into a principal of $4,073.59 and an interest of $229.73. (Total payment of $4,303.32 for month two.)
Continue doing this for every month of the loan’s term. You’ll notice that as the total principal amount is reduced each month so is the corresponding amount of interest. And as the interest gradually declines, the percentage of your payment that goes to the principal gradually increases.
This, of course, is a simplified example. Most amortized loans span over a number of years — about five years for a car and as many as 25-30 years for a house — and therefore require a significant amount of calculations. These payments are organized in an amortization table or amortization schedule, and luckily, a lot of websites offer loan amortization calculators or financial calculators you can use at no cost. A few good ones to try are the ones from Credit Karma, Bankrate, and Calculate Stuff.
Reasons You Should Get an Amortization Loan
The ability to pay off an entire loan — principal and all — according to a set schedule is enough to get people signing up for an amortized loan. And true enough, there are a lot of benefits.
Probably the most important of which is that all payments are equal. Having a fixed payment that doesn’t change month to month makes budgeting and financial planning much easier. You can simply add this amount to your other monthly bills, say for utilities, rent, etc., and continue paying until the debt is gone.
In addition, amortized loans are more realistic and take into account what’s called “the true cost of borrowing.” Borrowers usually make their decision purely based on the principal monthly payments. They rarely think about all the other costs that come with a loan, such as interest rates, conversion fees, and any other miscellaneous charges.
Amortization loans add all these up and are a good way to determine if the true cost of borrowing is really worth it.
Reasons You Should Not Get an Amortization Loan
Amortized loans require you to pay off your principal and interest together, which can make the monthly payments quite steep. Unamortized loan types, such as interest-only loans or deferred interest loans, are usually much more affordable. Although the borrower doesn’t get any equity until they start making principal payments, unamortized loans are a better option if your income varies per month or you’re expecting to receive a large amount of funds at a later date (i.e., dividends, commission, asset sales).
Some may also prefer the clear-cut nature of unamortized loans — borrowers are sure that, at least in the beginning, each month’s payment only goes towards the total interest. When taking out an unamortized loan, however, it’s important to clarify the exact amounts that need to be paid, from the beginning to the end of the loan.
Depending on the plan, the month-to-month payments in unamortized loans may not be the same, especially when it comes time to pay the principal. As such, it’s important to be crystal clear on every detail of your plan, and be financially prepared to make all the agreed-upon payments.
To Amortize or Not to Amortize
As with all big financial decisions, whether you decide to get a loan that’s amortized or unamortized is really up to you. Although you will have a higher monthly repayment, these won’t change each month and are good if you are trying to stick to a fixed budget. Unamortized loans, however, do start with a lower monthly payment, but may incur a large increase when it comes time to pay the principal.
Whether amortized or unamortized, choose a payment plan that works well with your finances and one that you will feel comfortable with through the years.