What is an Amortized Loan?
An amortized loan is a type of loan with scheduled, periodic payments that are applied to both the loan’s principal amount and the interest accrued. An amortized loan payment first pays off the relevant interest expense for the period, after which the remainder of the payment is put toward reducing the principal amount. Common amortized loans include auto loans, home loans, and personal loans from a bank for small projects or debt consolidation.
Key Takeaways
- An amortized loan requires the borrower to make scheduled, periodic payments applied to both principal and interest.
- Payment initially covers interest expense, with the remainder reducing the principal.
- As the interest portion of payments decreases, the principal portion increases.
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 excess payment reduces the principal, which then decreases the balance on which the interest is calculated. Over time, the interest portion of an amortized loan decreases, and the principal portion of the payment increases. Thus, interest and principal have an inverse relationship over the loan’s life.
An amortized loan involves a set of calculations. The current balance is multiplied by the interest rate attributable to the current period to find the interest due. Subtracting the interest due from the total monthly payment identifies the principal paid in the period. This amount is applied to the outstanding loan balance, and the new balance is used to calculate the next period’s interest.
Amortized Loans vs. Balloon Loans vs. Revolving Debt (Credit Cards)
While similar, amortized loans, balloon loans, and revolving debt offer different financial experiences. Here are key distinctions:
Amortized Loans
Amortized loans are usually paid off over a longer term with fixed periodic payments, though there’s an option to pay more and reduce principal owed faster.
Balloon Loans
Balloon loans usually feature shorter terms with only a portion of the principal amortized. The remaining balance is paid as a large final payment at term-end.
Revolving Debt (Credit Cards)
Revolving debt like credit cards lets you borrow up to a set credit limit and repay as per your convenience. It contrasts with amortized loans, as it lacks fixed payment amounts or set loan amounts. Payments in amortized loans initially pay more interest than principal, reversing over time.
Example of an Amortization Loan Table
An amortization table lists relevant balances and dollar amounts for each payment period. Below is an excerpt of such a table for the first year of a 30-year mortgage at $165,000 with a 4.5% annual interest rate:
Can I Pay Off an Amortized Loan Early?
Yes, you can pay off an amortized loan early by making extra or more frequent principal payments, thus lowering the amount that accrues interest. Check your loan agreement for early payoff penalties before proceeding.
How Can I See How Much of My Payment Is Interest?
Most lenders provide amortization tables showing the breakdown of each payment between principal and interest. This information is also available upon request.
Do I Pay More Interest at the Beginning or End of My Loan?
Amortized loans generally start with payments more heavily weighted toward interest, which then reverses over time.
The Bottom Line
An amortized loan addresses both projected interest and principal amounts. Making extra principal payments can help lower your loan amount if allowed. Utilize an amortization calculator to analyze potential interest versus principal costs for different loans.
Related Terms: principal, interest, amortization schedule, debt consolidation, mortgage.
References
- Experian. “What Is an Amortized Loan?”
- Consumer Financial Protection Bureau. “What Is a Balloon Payments? When Is One Allowed?”
