
There are two types of amortization. One relates to the way certain business expenses are deducted, which we discussed in Section 2. The other relates to the way a loan is repaid, which we'll discuss here.
Amortization describes the paying off of debt in regular installments over a period of time. An amortized loan has scheduled periodic payments of both principal and interest. With a selfamortizing loan, the periodic payments consist of both principal and interest in an amount such that the loan will be paid off by the end of a scheduled term. Assuming the loan is a fixedrate loan, the amount of each payment and the breakdown of the principal and the interest that comprise each payment can be known in advance. If the loan is an adjustablerate loan, it can still be selfamortizing, but because the interest rate is subject to change, the amount and breakdown of each payment cannot be known in advance.
Borrowers who choose fully amortized loans are less likely to experience "payment shock" than borrowers who choose loans that are not fully amortized. Payments on loans that are not initially fully amortized must at some point become amortized over the remaining term of the loan in order for the outstanding principal balance to be repaid. The shorter the remaining term, the larger the increase required in the periodic payments to amortize the loan over the remaining term.
With a fully amortizing loan, the principal balance decreases with each payment. With a negatively amortizing loan, the principal balance increases each month because the payments fail to cover the interest due. The unpaid interest, called "deferred interest," is added to the loan's principal, which ultimately causes the borrower to owe more money.
For example, consider a loan with an 8% annual interest rate, a remaining principal balance of $100,000, and a provision that allows the borrower to make $500 payments at a certain number of scheduled payment dates. The interest due on the loan at the next scheduled payment would be: 0.08 / 12 x 100,000 = $666.67. If the borrower makes a $500 payment, $166.67 in deferred interest ($666.67  $500) will be added to the principal balance of the loan for a total remaining principal balance of $100,166.67. The next month's interest charge would be based on this new principal balance amount, and the calculation would continue each month leading to increases in the loan's principal balance or negative amortization.
Negative amortization cannot continue indefinitely. At some point, the loan must start to amortize over its remaining term. Typically, negatively amortizing loans have scheduled dates when the payments are recalculated, so that the loan will amortize over its remaining term, or they have a negative amortization limit which states that when the principal balance of the loan reaches a certain contractual limit the payments will be recalculated.
With a nonamortizing loan, payments on the principal are not made, while interest payments or minimum payments are made regularly. As a result, the value of principal does not decrease at all over the life of the loan. The principal is then paid as a lump sum at the maturity of the loan. Examples of nonamortizing loan agreements are balloon mortgages and deferred interest programs.
An amortization schedule is a chart showing a complete breakdown of periodic blended loan payments. It shows the amount of principal and the amount of interest that comprise each payment so that the loan will be paid off at the end of its term. Early in the schedule, the majority of each periodic payment is interest. Later in the schedule, the majority of each periodic payment is put toward the principal.
If you know the term of a loan and the total periodic payment, an easy way to calculate an amortization schedule is to do the following: Starting in month one, multiply the loan balance by the periodic interest rate. This will be the interest amount of the first month's payment. Subtract that amount from the total payment, which will give you the principal amount.
To calculate the next month's interest and principal payments, subtract the principal payment made in month one from the loan balance, and then repeat the steps from above.
As an alternative, you can let a loan amortization calculator do the work for you.
Introduction To Bonds
Borrowers who choose fully amortized loans are less likely to experience "payment shock" than borrowers who choose loans that are not fully amortized. Payments on loans that are not initially fully amortized must at some point become amortized over the remaining term of the loan in order for the outstanding principal balance to be repaid. The shorter the remaining term, the larger the increase required in the periodic payments to amortize the loan over the remaining term.
With a fully amortizing loan, the principal balance decreases with each payment. With a negatively amortizing loan, the principal balance increases each month because the payments fail to cover the interest due. The unpaid interest, called "deferred interest," is added to the loan's principal, which ultimately causes the borrower to owe more money.
For example, consider a loan with an 8% annual interest rate, a remaining principal balance of $100,000, and a provision that allows the borrower to make $500 payments at a certain number of scheduled payment dates. The interest due on the loan at the next scheduled payment would be: 0.08 / 12 x 100,000 = $666.67. If the borrower makes a $500 payment, $166.67 in deferred interest ($666.67  $500) will be added to the principal balance of the loan for a total remaining principal balance of $100,166.67. The next month's interest charge would be based on this new principal balance amount, and the calculation would continue each month leading to increases in the loan's principal balance or negative amortization.
Negative amortization cannot continue indefinitely. At some point, the loan must start to amortize over its remaining term. Typically, negatively amortizing loans have scheduled dates when the payments are recalculated, so that the loan will amortize over its remaining term, or they have a negative amortization limit which states that when the principal balance of the loan reaches a certain contractual limit the payments will be recalculated.
With a nonamortizing loan, payments on the principal are not made, while interest payments or minimum payments are made regularly. As a result, the value of principal does not decrease at all over the life of the loan. The principal is then paid as a lump sum at the maturity of the loan. Examples of nonamortizing loan agreements are balloon mortgages and deferred interest programs.
An amortization schedule is a chart showing a complete breakdown of periodic blended loan payments. It shows the amount of principal and the amount of interest that comprise each payment so that the loan will be paid off at the end of its term. Early in the schedule, the majority of each periodic payment is interest. Later in the schedule, the majority of each periodic payment is put toward the principal.
If you know the term of a loan and the total periodic payment, an easy way to calculate an amortization schedule is to do the following: Starting in month one, multiply the loan balance by the periodic interest rate. This will be the interest amount of the first month's payment. Subtract that amount from the total payment, which will give you the principal amount.
To calculate the next month's interest and principal payments, subtract the principal payment made in month one from the loan balance, and then repeat the steps from above.
As an alternative, you can let a loan amortization calculator do the work for you.
Related Articles

Personal Finance
InterestOnly Mortgages: Home Free or Homeless?
These loans can be beneficial, but for many borrowers, they present a financial trap. 
Investing
How to Save Money on Your Mortgage
These strategies can potentially save you thousands of dollars over the length of a mortgage. 
Personal Finance
Time To Consolidate Your Student Loans?
Use these strategies to decide whether consolidating your student loans makes sense for you – and what to do next if it does. 
Personal Finance
Crush Your Student Loan Debt With These Tips
Conquering highinterestrate loans first and paying extra can help you crush your student loans. 
Investing
4 Ways Simple Interest Is Used In Real Life
Simple interest works in your favor when you're a borrower, but against you when you're an investor. 
Investing
Financial Institutions: Stretched Too Thin?
Find out how to evaluate a firm's loan portfolio to determine its financial health. 
Personal Finance
An Introduction to Federal Direct Loans
Federal Direct Loans provide student funding that a majority of people can easily access. Find out if you qualify. 
Personal Finance
Should You Lend Money to Family or Friends?
Find out how loaning cash to help family or friends can put a strain on your relationship and your bank account. Learn how to make family loans safer. 
IPF  Mortgage
How to Choose the Best Mortgage
Finding the right house is only half the battle. The other half is choosing the best type of mortgage. Learn how to pick a mortgage based on your needs.