Amortizing Security

What Is an Amortizing Security?

An amortizing security is a class of debt investment in which a portion of the underlying principal amount is paid in addition to interest with each payment made to the security's holder. The regular payment that the security holder receives is derived from the payments that the borrower makes in paying off the debt.

Amortizing securities are debt-backed, meaning a loan or a pool of loans has been securitized. From the borrower's perspective, nothing has changed from the original loan agreement, but the payments made to the bank flow through to the investor who holds the security created from the loan. Mortgages and mortgage-backed securities are common forms of amortizing securities.

It can be contrasted with a non-amortizing security.

Key Takeaways

  • Amortizing securities are debt securities like bonds, but they pay the principal back with each payment rather than upon maturity.
  • Most corporate or government bonds pay back principal only at the end of the loan's term, and are therefore non-amortizing.
  • Mortgages and mortgage-backed securities (MBS) are among the most common forms of an amortizing security.
  • Depending upon the way in which a security is structured, holders of amortizing securities may be subject to prepayment risk.
  • It is not uncommon for the underlying borrower to prepay a portion, if not all, of the debt's principal if interest rates drop to a point where refinancing makes financial sense.

How an Amortizing Security Works

Amortizing securities are debt securities like bonds, but they pay the principal back with each payment rather than upon maturityMortgage-backed securities (MBS) are among the most common forms of an amortizing security.

With an MBS, the monthly mortgage payments that the borrowers make are pooled together and are then distributed to MBS holders. This is an excellent system for freeing up credit to issue more loans as long as the creditor is properly vetting borrowers.

Another popular type of amortizing security would be car loans since repayment by the borrower generally includes interest plus principal payments. Pools of these loans are called Asset-Backed Securities (ABS). Prepayment speeds for these types of loans can be quite different compared to MBS.

Amortizing securities in the form of mortgages and NINJA loans were at the center of the mortgage meltdown.

Amortizing Securities and Prepayment Risk

Depending upon the way in which a security is structured, holders of amortizing securities may be subject to prepayment risk. It is not uncommon for the underlying borrower to prepay a portion, if not all, of the debt's principal if interest rates drop to a point where refinancing makes financial sense.

In the event that prepayment occurs, the investor will receive the rest of the principal and no more interest payments will occur. This leaves the investor with dollars to invest in a lower interest environment than was likely the case when they purchased the amortizing security.

As a consequence, the investor will lose out on interest that they may have otherwise enjoyed if they hadn't chosen an amortizing security. This is also referred to as reinvestment risk, and it is part of the trade-off investors must make for a higher interest rate on an amortizing security compared to a non-amortizing bond.

Stripping Amortizing Securities

Because of the unique two-portion payments, an amortizing security can be stripped into interest-only and principal-only products, or some combination where the proportion of the two are unequally allotted to a tranche.

The interest-only strip will take on all the prepayment risk and the principal-only strip actually benefits from prepayment because the investor gets the money back sooner, benefiting from the time value of money since there is no interest coming anyway. In this case, the two strips of an amortizing security become proxies for the investor's thesis on the future movement of interest rates.

Example of an Amortizing Security

A traditional mortgage is an example of an amortizing security, since both a portion of principal and interest is paid off each month. With a fully-amortizing payment, most conventional mortgages have the same monthly payment over the life of the loan, with the portion of interest vs. principal, favoring principal over time as the loan balance is paid off.

The amortization Schedule for a 30-Year $250,000 mortgage at 4.5%, for instance, would therefore be $1,266.71 per month. In the first month of the loan, $329.21 of the payment is principal and $937.50 is interest. In the final payment, $412.11 would be principal and $854.61 in interest.

Note that some mortgages are not amortizing, such as interest-only and balloon mortgages. ARM mortgages may only become amortizing after an initial period of, say, five years (in the case of a 5/1 ARM).

What Does It Mean When a Loan Is Amortizing?

Amortizing means that the loan's payments include both a portion of interest and principal. In a non-amortizing loan, only interest payments are made periodically, with the entire amount of the principal repaid only at the loan's maturity.

Why Do Banks Amortize Loans?

Banks may prefer to amortize loans because these favor interest over principal in the early years, and banks know that most homeowners will refinance or sell their property before the 30 years of a traditional mortgage are up. This allows the bank to capture the most interest income while also minimizing credit risk since the principal is also being repaid each month. The principal portions can also be used to make new loans or investments as they are received.

What Is a Negatively Amortized Loan?

A negatively amortized loan allows the borrower to make occasional payments that are less than the full amount of interest due. This deferred interest is then added to the loan's outstanding principal. The amount of interest that can be deferred in this way is often capped.

How Do I Pay Off My Amortization Schedule Early?

Many lenders allow you to repay extra principal or make extra payments early. When this happens, you can either maintain the same monthly payments but shorten the length of the loan. Or you can keep the existing term of the loan and recast it with lower monthly payments. Note that some loans will include prepayment or early termination penalties. Check the fine print with your lender.