Understanding Loan Amortization: What Is It? How Does It Work?

Understanding Loan Amortization: What Is It? How Does It Work?

Loan amortization provides borrowers with a clear and consistent picture of how much they will be repaying during each repayment cycle. Borrowers will have a fixed repayment schedule over the repayment period of the loan. Payments will be made in regular installments in a set amount that consists of both principal and interest. Common examples of amortized loans include student loans, car loans and home mortgages.

What Is Loan Amortization?

With an amortized loan, the ratio of principal to interest will change throughout the repayment period. The change in principal and interest is detailed in an amortization schedule. The amount applied to interest will generally be greater towards the beginning of the repayment period and will decrease as time goes on. Conversely, the amount applied to the principal will be less towards the beginning of the repayment period and will increase towards the end. An unamortized loan, on the other hand, would consist of interest-only payments during the bulk of the repayment period and end with a balloon payment for the remaining principal.

For example, if a business borrowed $10,000 for a term of one year at 5% APR (annual percentage rate), its amortization schedule would be the following if it started to repay immediately:

PaymentPayment AmountAmount Applied to PrincipalAmount Applied to InterestRemaining Balance

The business' payments would remain the same at $856.07 throughout the 12 payments during the entire repayment period, but the amounts applied to the principal and interest would slowly change. Her first interest payment would be $41.67 and her last interest payment would only be $3.55. Her first principal payment would be $814.40 and her last would be $852.52. Regardless of the change in principal and interest, her payment is consistently $856.07 throughout the life of the loan.

Amortized vs. Unamortized Loans

An amortized loan is more common and more beneficial for most people, but whether you should get an amortized loan will depend on your unique circumstances. Because amortized loans allow you to pay off both principal and interest at the same time, you gain equity in the asset, such as a house or a car, with each payment. In addition, each month you know exactly the amount you will be paying since it stays the same. Knowing that your payments won’t change month to month makes financial planning easier and more effective.

One thing to be aware of is that the amount of your monthly payments can be quite high because you will be paying both principal and interest. Another drawback to amortized loans is that many consumers aren’t aware of the true cost of the loan. While the monthly payment of a loan may seem to fit in your budget, you should always calculate the total amount in interest that you will pay to determine the actual cost of taking out the loan.

For some people, unamortized loans are a more attractive option because of the lower interest-only payments. Although you aren’t paying any principal at the outset (and as such not gaining equity), unamortized loans provide low affordable payments until you come into a large amount of cash. Unamortized loans work best for people who receive sporadic lump-sum payments, such as those who rely on bonuses, commission or contract completion (e.g., real estate contractors).

Unamortized loans are more straight-forward since you know each monthly payment is only going towards interest. This makes it easier to calculate the actual cost of the loan. The trade-off for lower interest-only payments is that towards the end of the repayment period, you will have a balloon payment that will go towards principal. Planning ahead is crucial to ensure that you don’t become delinquent given the change in payment amount.

Knowing how much you will pay every month and how much total interest you will pay is important in making any borrowing decisions. This information will help you determine if the cost of the loan is actually worth it for your needs.

Justin is a Sr. Research Analyst at ValuePenguin, focusing on small business lending. He was a corporate strategy associate at IBM.