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.
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 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 amortized 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.
Types of Amortizing Loans
Most installment loans are amortizing loans, and the borrower pays the outstanding balance of the loan using a series of fixed-amount payments that cover the interest portion and the portion of the loan’s principal. The following are the main types of amortizing loans:
Home loans are fixed-rate mortgages that borrowers take to buy homes; they offer a longer maturity period than auto loans. A home loan comes with a fixed-rate interest rate, and borrowers can calculate the period they will take to pay off the principal and interest to arrive at a monthly payment. The borrower will then pay a series of fixed monthly payments throughout the term of the mortgage.
Most homeowners do not hold the mortgage for the entire 15- to 30-year period. Instead, they can refinance the loan or sell the home to pay off the outstanding balance. Most borrowers prefer fixed-rate mortgages because they can predict the pattern of their periodic payments in the future, even if there is a change in the interest rates.
An auto loan is a loan taken with the goal of purchasing a motor vehicle. It is a type of installment loan that is structured in fixed monthly repayments that are spread over a five-year period or shorter. In auto loans, the borrower agrees to pay back the principal and interest until the total loan amount is fully paid. The loans are backed by the value of the motor vehicle being purchased, and the borrower does not fully own the motor vehicle until the outstanding balance of the loan is fully paid.
An auto loan can be categorized into two forms, i.e., direct loan and indirect loan. A direct auto loan is a loan where the borrower obtains funds directly from a lender with the goal of purchasing a motor vehicle from a dealer. The borrower, in this case, is required to make monthly payments to the lender according to the agreed terms.
An indirect loan is a financial arrangement where the car dealership sells a motor vehicle to the borrower on credit terms. The dealer and the buyer enter into an installment sale contract, and the dealer sells the sale contract to a financial institution. The borrower will then pay off the loan as he/she would pay a direct loan.
Personal loans are loans that individual borrowers take from banks, credit unions, and other financial institutions. Such loans require borrowers to pay back the loan principal and interest in fixed monthly payments over a period of two to five years.
Borrowers can use personal loans for a specific purpose, such as to purchase a car or house, pay for college or vacation expenses, or settle hospital bills. Depending on the amount of credit applied, the loan may be secured or unsecured. Secured personal loans may require the borrower to provide a motor vehicle, house, or other assets as collateral.