What Is a Self-Amortizing Loan?
A self-amortizing loan is one for which the periodic payments, consisting of both principal and interest, are made on a predetermined schedule, ensuring that the loan will be paid off by the end of an agreed-upon term. Payments of this kind are known as fully amortizing payments. This type of mortgage is the default structure of mortgage loans unless otherwise specified. A self-amortizing loan is also known as an amortization loan.
How a Self-Amortizing Loan Works
A self-amortizing loan is typical of mortgage loans in general. With these mortgage loans the payments made are put toward both the interest on the borrowed amount and the balance, or principal, of the loan. The amount and proportion paid to interest and balance vary widely, even within the same mortgage. These differences are due to interest rates and structures of the varying types of loans, which can make interest rates and payments fluctuate.
Assuming the loan is a fixed-rate loan, monthly payments amounts will remain fixed, and the funds allocated to interest and principal are known. Borrowers may look at an amortization schedule that shows periodic loan payments and the amount of principal and interest that make up each payment until the loan is paid off at the end of its term.
The same is not true for an adjustable-rate mortgage (ARM). An ARM can still be self-amortizing but, because the interest rate is subject to change, the exact amount and breakdown of each payment cannot be predicted in advance.
[Important: Self-amortizing loans are structured to help the lender and borrower manage risk and create consistency and stability for both parties.]
Self-Amortizing Loans vs. Other Loans
Most traditional mortgages are self-amortizing loans. However, interest-only mortgages and payment-option adjustable-rate mortgages (ARMs) are examples of mortgages that are not entirely self-amortizing. In an interest-only mortgage, the payments for a certain number of years consist only of interest, after which the mortgage becomes self-amortizing for the remaining term.
Using a payment-option ARM, interest-only or negatively amortizing payments may be made at the beginning. However, at some point the mortgage must begin to self-amortize. Payment-option ARMs have triggers that reset the minimum payment option periodically to a self-amortizing payment to ensure that the mortgage will be paid off by the end of its scheduled term.
A bullet loan is one in which—although the borrower makes payments of either only interest or interest and principal—there is nevertheless a substantial lump-sum payoff of the remaining principal, called a “balloon payment,” as the last payment of the loan. Lenders charge a higher interest rate on bullet loans because they are much riskier for the lender than self-amortizing loans, which are structured to help the lender and borrower manage risk and create consistency and stability for both parties.