What Is an Amortized Loan?
An amortized loan is a loan with scheduled periodic payments that are applied to both principal and interest. An amortized loan payment first pays off the relevant interest expense for the period, after which the remainder of the payment reduces the principal. Common amortized loans include auto loans, home loans and personal loans from a bank for small projects or debt consolidation.
How an Amortized Loan Works
Because interest is calculated based on the most recent ending balance of the loan, the interest portion of the loan payment decreases as payments are made. This is because any payment in excess of the interest amount contributes to reducing the principal, and this reduces the balance on which interest is calculated. As the interest portion of an amortization 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 for 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.
[Important: Amortized loans apply each payment to both interest and principal, initially paying more interest than principal until eventually that ratio is reversed.]
Amortized Loans vs. Balloon Loans, Revolving Debt and Credit Cards
Here's how you can tell these three loan types apart. When you're taking out a loan, be sure that you're getting the kind you need.
- Amortized loans are generally paid off over an extended period of time by equal amounts for each payment period, though there is always the option to pay more and thus further reduce capital.
- Balloon loans, on the other hand, typically feature a relatively short term, and only a portion of the loan's principal balance is amortized over that term. At the end of the term, the remaining balance is due as a final repayment, which is large, generally at least double the amount of previous payments.
- Revolving debt and credit cards do not have the same features of an amortized loan, as they do not have set payment amounts or a fixed loan amount.
Example of an Amortization Loan Table
The calculations of an amortized loan may be displayed in an amortization table. The table lists relevant balances and dollar amounts for each period. In the example below, each period is a row in the table, while the columns are payment date, principal portion of payment, interest portion of payment, total interest payment to date, and ending outstanding balance. The following table excerpt is for the first year of a 30-year, $165,000 mortgage, at an annual interest rate of 4.5%