There are two types of amortization. One relates to the way certain business expenses are deducted, which we discussed in Section 2. The other relates to the way a loan is repaid, which we'll discuss here. Amortization describes the paying off of debt in regular installments over a period of time. An amortized loan has scheduled periodic payments of both principal and interest. With a self-amortizing loan, the periodic payments consist of both principal and interest in an amount such that the loan will be paid off by the end of a scheduled term. Assuming the loan is a fixed-rate loan, the amount of each payment and the breakdown of the principal and the interest that comprise each payment can be known in advance. If the loan is an adjustable-rate loan, it can still be self-amortizing, but because the interest rate is subject to change, the amount and breakdown of each payment cannot be known in advance.

Borrowers who choose fully amortized loans are less likely to experience "payment shock" than borrowers who choose loans that are not fully amortized. Payments on loans that are not initially fully amortized must at some point become amortized over the remaining term of the loan in order for the outstanding principal balance to be repaid. The shorter the remaining term, the larger the increase required in the periodic payments to amortize the loan over the remaining term.

With a fully amortizing loan, the principal balance decreases with each payment. With a negatively amortizing loan, the principal balance increases each month because the payments fail to cover the interest due. The unpaid interest, called "deferred interest," is added to the loan's principal, which ultimately causes the borrower to owe more money.

For example, consider a loan with an 8% annual interest rate, a remaining principal balance of $100,000, and a provision that allows the borrower to make $500 payments at a certain number of scheduled payment dates. The interest due on the loan at the next scheduled payment would be: 0.08 / 12 x 100,000 = $666.67. If the borrower makes a $500 payment, $166.67 in deferred interest ($666.67 - $500) will be added to the principal balance of the loan for a total remaining principal balance of $100,166.67. The next month's interest charge would be based on this new principal balance amount, and the calculation would continue each month leading to increases in the loan's principal balance or negative amortization.

Negative amortization cannot continue indefinitely. At some point, the loan must start to amortize over its remaining term. Typically, negatively amortizing loans have scheduled dates when the payments are recalculated, so that the loan will amortize over its remaining term, or they have a negative amortization limit which states that when the principal balance of the loan reaches a certain contractual limit the payments will be recalculated.

With a non-amortizing loan, payments on the principal are not made, while interest payments or minimum payments are made regularly. As a result, the value of principal does not decrease at all over the life of the loan. The principal is then paid as a lump sum at the maturity of the loan. Examples of non-amortizing loan agreements are balloon mortgages and deferred interest programs.

An amortization schedule is a chart showing a complete breakdown of periodic blended loan payments. It shows the amount of principal and the amount of interest that comprise each payment so that the loan will be paid off at the end of its term. Early in the schedule, the majority of each periodic payment is interest. Later in the schedule, the majority of each periodic payment is put toward the principal.

If you know the term of a loan and the total periodic payment, an easy way to calculate an amortization schedule is to do the following: Starting in month one, multiply the loan balance by the periodic interest rate. This will be the interest amount of the first month's payment. Subtract that amount from the total payment, which will give you the principal amount.

To calculate the next month's interest and principal payments, subtract the principal payment made in month one from the loan balance, and then repeat the steps from above.

As an alternative, you can let a loan amortization calculator do the work for you.



Introduction To Bonds

Related Articles
  1. Personal Finance

    Mortgage Amortization Strategies

    Should you get a 30-year mortgage? A 15-year one? Ways to decide which mortgage is the best fit.
  2. Personal Finance

    Simple Interest Loans: Do They Exist?

    Yes, they do. Here is what they are – and how to use them to your advantage.
  3. Personal Finance

    Understanding the Mortgage Payment Structure

    We explain the calculation and payment process as well as the amortization schedule of home loans.
  4. Personal Finance

    10 Tips to Topple Student Loan Debt

    How to manage those burdensome payments as you embark on adult life.
  5. Investing

    Commercial Real Estate Loans

    Obtaining a commercial real estate loan is quite different from borrowing for residential real estate. Here's what to expect and how to get what you need.
  6. Personal Finance

    How Interest Rates Work On A Mortgage

    A step-by-step explanation of the interest calculations, mortgage types, and how the loan is eventually "retired" – which means paid off.
  7. Investing

    4 Ways Simple Interest Is Used In Real Life

    Simple interest works in your favor when you're a borrower, but against you when you're an investor.
  8. Personal Finance

    Schedule Loan Repayments with Excel Formulas

    Calculate all the particulars of a loan using Excel, and set up a schedule of repayment for a mortgage or any other loan.
  9. Retirement

    Business Owners: A Guide To Qualified Retirement Plan Loans

    Thinking of adding a loan feature to your company's plan? Here's what you need to know.
Frequently Asked Questions
  1. What is a reasonable amount of debt?

    It really depends on numerous factors - what stage of life you are at, your spending and saving habits, the stability of ...
  2. How are IRA withdrawals taxed?

    Learn how IRA withdrawals are taxed at retirement age and for qualified withdrawals. Consider the different tax consequences ...
  3. How does CareCredit for pets work?

    Understand how using a CareCredit credit card aids pet parents in the payment of potentially high veterinary care costs.
  4. Do 401k contributions reduce AGI and/or MAGI?

    Discover how contributing to a 401(k) plan can reduce your AGI and/or MAGI. Also learn by how much and how this differs from ...
Trading Center