A famous Danish proverb says,
Promises make debt, and debt makes promises.
Corporate finance and personal finance both focus on two main sources of financing: debt and equity. Debt financing is the mode by which businesses and individuals borrow money from financial institutions. The borrowed amount is called a loan, and it is paid back to the lender on pre-decided terms of payment.
Businesses go toward debt financing when they want to purchase a plant, machinery, land, or product research. In personal finance, bank loans are usually dedicated to real estate purchases, car purchases, etc. An interest percentage is paid to the bank until the loan is repaid.
There are specific types of loans that are amortized and other types that are not amortized. This article will have a general overview of loan amortization, how it works, and what types of amortized, and which ones are not.
So let’s get into it.
What is an amortized loan?
An amortized loan is defined as,
a type of loan or debt financing that is paid back to the lender within a specified time. The repayment structure of such a loan is such that every periodic payment has an interest amount and a certain amount of the principal.
A more formal definition of the amortized loan will be,
An amortized loan is a scheduled loan in which periodic payments consist of interest amount and a portion of the principal amount.
What Is Loan Amortization?
Amortization is a broader term that is used for business intangibles as well as loans. For intangibles, the amortization schedule divides the value of the intangible assets over the asset’s useful life. However, it works similarly in the case of loans, but the payment structure is different.
Loan amortization can be defined as,
It is paying back the loan taken from financial institutions or independent lenders so that every installment is scheduled and consists of two portions: interest accrued and principal amount.
The fixed rate of interest is deducted from the pre-scheduled installment in each period. The remaining amount is treated as a part of the principal. At the end of the amortization schedule, there is no amount due on the borrower.
Types Of Amortizing Loans
Not all loans are amortized loans. Instead, there are certain types of loans that can be amortized. In personal finance, the following are the most common types of amortization loans:
Home loan
Home loans are usually fixed-mortgage loans spread over 15 to 30 years. The borrower has security that he will pay the fixed interest respect regardless of the market fluctuations. However, another type of flexible-rate mortgage also exists when the lender has the power to change the rate.
Personal loan
Personal loans were taken from online lenders, credit unions, and other financial institutions like banks fall in the category of personal loans and are usually amortized. The terms of personal loans can vary. However, most typically, such loans are spread over three to five years.
Auto loan
Auto loans or car loans are borrowed for car purchases. The loan schedule consists of a down payment and periodic payments of interest+principal.
Such loans are usually for five years or less. The borrower can extend the loan, but it can put you at the risk of paying more than the resale value of your vehicle.
Student loans
Student loans cover the tuition fees, education costs, college expenses, etc., for the students during their studies. The repayment of student loans depends on who is the lender; federal loans or private loans. Private loans usually have higher interest rates, and federal loans are issued at subsidized rates.
What Kinds Of Loans Are Not Amortized?
Some common types of loans are not amortized, and such loans include:
- Credit card loans
- Balloon loans
- Interest-only loans
How Does Amortization Work?
If we break down the definition of amortization, we will get the following building blocks:
Scheduled payments: it means that the periodic payments are made over a specified period of time.
Pre-decided fixed payments: the fixed interest rate is charged in every periodic payment
Interest amount: the periodic payments consists of the interest accrued.
Principal amount: the second portion of each payment is the principal amount. With every periodic payment, the due amount of principal reduces until it is fully paid by the end of the amortization schedule.
From the following points, it can be understood how loan amortization works. When the borrower approaches the lender for the loan, the borrowers make an amortization table or schedule to divide the loan amount and interest throughout the loan period.
The amortization table also helps the borrower prioritize their strategy for paying the loan. A borrower can estimate how much money he can save by paying more as a down payment or rescheduling the amortization table for a smaller period of time.
Similarly, it also gives an overview of the annual interest payment to be filed in the tax return.
How To Calculate Loan Amortization?
You can find an online calculator that will find a complete amortization schedule for you with periodic payments and writing off the principal amount.
However, you can also prepare your loan amortization schedule by hand or in MS excel. Let’s look at the formula periodic payments in the loan amortization.
What will you need:
- Total amortization period(years, months, etc., specifying how long will you take to pay off the loan)
- Frequency of payments(annual, monthly, biannual, quarterly, etc.)
- Interest rate
The following formula will be applied for the monthly payments in the amortization schedule:
p = a/{[(1+r)n]-1}/[r(1+r)n]
in this formula, the annotations represent the following:
a = total amount of loan
r= interest rate(monthly, annually, quarterly; it can be converted)
n = total number of payments in the total period of the loan; calculated by frequency of payments.
Example
Let’s understand the example of loan amortization with an example.
Let’s suppose Marina has taken a personal loan of 14,000 USD for two years at the annual interest rate of 6%. The loan will be amortized over two years with monthly payments. Every monthly payment will consist of monthly interest and a part of the principal amount.
Let’s find out the monthly installments.
p = a/{[(1+r)n]-1}/[r(1+r) n]
a = 14,000 USD
r = 5% per annum = 6/12 = 0.5%
n = 24
p = 14,000/ {[(1+0.005) 24]-1}/[0.005(1+0.005) 24]
p = 14000/ 22.55
p = 620.67 USD per month.
Every monthly payment will be 620.67 USD. Let’s find out the interest payment and principal payment.
The interest payment per month will be calculated as,
Interest payment(monthly) = loan amount X interest rate/12
Monthly interest payment = 14,000 USD x 0.06/12
Monthly interest payment = 70 USD
The remaining amount in each periodic payment will be the principal repayment.
Amortization Table
We’ve already discussed how to calculate the monthly installments in loan amortization and the amount of monthly interest.
The amortization table is the most important in loan amortization as it gives an overview of the monthly payments, principal writing off, interest amount, etc., to the borrower. The amortization table consists of the following amounts:
Loan Amount: the total amount of loan borrowed from the lender is recorded along with other details like the term of payments, interest rate, etc.,
Payment frequency: The first column in the amortization table records what will be the payment frequency. Payment frequency shows how many times you will make payments in a year(monthly, quarterly, etc.)
Total payment to the lender: each month, the installment you’ll pay to the lender is recorded in this column.
Extra payment: the monthly payment consists of interest and principal amount. However, the borrower can choose to pay more than the minimum monthly installment to repay the loan earlier than decided. If the borrower avails of this option, the principal amount is written off, and the amount beyond the monthly installment is recorded in this column.
Remaining balance: the column records the remaining balance of the principal loan after every installment.
Interest costs: the interest costs in every period (depending on payment frequency) are recorded in the amortization schedule. The interest costs have a diminishing trend as the amount decreases with decreasing principal.
Let’s look at the example of the loan amortization schedule of the above example for the first six months.
The amount due is 14,000 USD at a 6% annual interest rate and two years payment period. The repayment will be made in monthly installments comprising interest and principal amount.
| Month | Beginning Balance USD | Interest USD | Principal USD | Ending Balance USD |
| 1 | 14,000 | 70 | 550.67 | 13,449.33 |
| 2 | 13,449.33 | 67.24 | 553.423 | 12,895.90 |
| 3 | 12,895.90 | 64.4795 | 556.1904 | 12,339.70 |
| 4 | 12,339.70 | 61.6985 | 558.97 | 11,780.72 |
| 5 | 11,780.72 | 58.903 | 561.766 | 11,218.95 |
| 6 | 11,218.95 | 56.0946 | 564.57 | 10,654.31 |
| 7 | 10,654.31 | 53.2717 | 567.39 | 10,086.911 |
| 8 | 10,086.911 | 50.43 | 570.235 | 9,516.67 |
| 9 | 9,516.67 | 47.58 | 573.086 | 8,942.91 |
| 12 | – | – | – | 0 USD |
Conclusion
From the above discussion, you will have got a clear idea of how the loan amortization works and how to make the loan amortization table for your convenience. We have also discussed which types of loans are amortized and the types that are unamortized.
However, it is also important to note that loan amortization is common in personal finance. Incorporate finance; the amortization principle is generally applicable to intangible assets.
