What is a Self-Amortizing Loan
A self-amortizing loan is one which the periodic payments consist of both principal and interest such that the loan will be paid off by the end of a scheduled term. Payments of this kind are known as fully amortizing payments. This type of mortgage is the default structure of mortgage loans unless specified otherwise. A self-amortizing loan is also known as an amortization loan.
BREAKING DOWN Self-Amortizing Loan
A self-amortizing loan is typical of mortgage loans in general. With these mortgage loans, the payments made consist partly of money paid toward the interest on the borrowed amount, and partially toward 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 known. Borrowers may look at an amortization schedule which shows periodic loan payments, and the amount of principal and interest that comprise 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 amount and breakdown of each payment cannot be exact.
Most traditional mortgages are self-amortizing loans; however, interest-only mortgages and payment option adjustable-rate mortgages (ARM) are examples of mortgages that are not entirely self-amortizing. In an interest-only mortgage, the payments for a certain number of years consists 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 which reset the minimum payment option periodically to a self-amortizing payment to ensure the mortgage will be paid off by the end of its scheduled term.
Self-Amortizing Loans vs. Bullet Loans
A self-amortizing loan follows a schedule which involves paying the principal of the note in increments, over time, until the loan is paid off at the scheduled time. Conversely, a bullet loan is a one in which the borrower makes payments of only interest or interest and principal, but there is a substantial lump sum payoff of a portion of the principal as the last payment of the loan. Lenders charge a higher interest rate on bullet loans, as they are much riskier for the lender than self-amortizing loans are. Self-amortizing mortgages help both the lender and the borrower manage risk, and provide a loan structure that defaults to consistency and stability for both parties to the loan.