An amortized loan is a loan with scheduled periodic payments that consist of both principal and interest. An amortized loan payment pays the relevant interest expense for the period before any principal is paid and reduced. This is opposed to loans with interest-only payment features, balloon payment features and even negatively amortizing payment features.
The most common examples of an amortized loan are auto loans, home loans and personal loans from a bank for small projects or debt consolidation. 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.
Relationship Between Principal and Interest
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 in 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.
There are a series of calculations regarding an amortized loan. First, the current balance of the loan is multiplied by the interest rate attributable for the current period to find the interest for the period. Annual interest rates may be divided by 12 to find a monthly rate. The interest for the period represents the portion of the payment attributable to interest. Therefore, subtracting the interest 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.
The calculations of an amortized loan may be displayed in an amortization table. The table lists relevant balances and dollar amounts for each period. Each period is a row in the table, while the columns are typically current loan balance, total monthly payment, interest portion of payment, principal portion of payment and ending outstanding balance. The ending outstanding loan balance of one period becomes the current loan balance for the next.
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