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.
- An amortized loan is a type of loan that requires the borrower to make scheduled, periodic payments that are applied to both the principal and interest.
- An amortized loan payment first pays off the interest expense for the period; any remaining amount is put towards reducing the principal amount.
- As the interest portion of the payments for an amortization loan 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 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.
Amortized Loans vs. Balloon Loans vs. Revolving Debt (Credit Cards)
While amortized loans, balloon loans, and revolving debt–specifically credit cards–are similar, they have important distinctions that consumers should be aware of before signing up for one.
Amortized loans are generally paid off over an extended period of time, with equal amounts paid for each payment period. However, there is always the option to pay more, and thus, further reduce the principal owed.
Balloon loans typically have 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 generally large (at least double the amount of previous payments).
Revolving Debt (Credit Cards)
Credit cards are the most well-known type of revolving debt. With revolving debt, you borrow against an established credit limit. As long as you haven't reached your credit limit, you can keep borrowing. Credit cards are different than amortized loans because they don't have set payment amounts or a fixed loan amount.
Amortized loans apply each payment to both interest and principal, initially paying more interest than principal until eventually that ratio is reversed.
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. The columns include the payment date, principal portion of the payment, interest portion of the payment, total interest paid to date, and ending outstanding balance. The following table excerpt is for the first year of a 30-year mortgage in the amount of $165,000 with an annual interest rate of 4.5%