Amortizing Loans

Definition

An amortizing loan is a type of loan where the debt is repaid in equal, regular installments over a set period of time. The payments include both principal and interest, with a portion of each payment going towards the outstanding balance and the remaining portion covering the interest charges.

5 Must Know Facts For Your Next Test

1. The principal balance on an amortizing loan decreases with each payment, as a portion of the payment goes towards paying down the outstanding balance.
2. The interest portion of an amortizing loan payment is highest at the beginning of the loan term and decreases over time as the principal balance is reduced.
3. Amortizing loans are commonly used for mortgages, auto loans, and other types of installment loans where the debt is repaid over an extended period.
4. The length of the loan term and the interest rate are key factors that determine the size of the periodic payments on an amortizing loan.
5. Amortizing loans typically have a fixed interest rate, although some may have variable rates that can change over the life of the loan.

Review Questions

• Explain the purpose and structure of an amortizing loan.
  • The purpose of an amortizing loan is to allow the borrower to repay the debt in equal, regular installments over a set period of time. The structure of an amortizing loan involves each payment consisting of both a principal component, which goes towards reducing the outstanding balance, and an interest component, which covers the cost of borrowing the money. This gradual repayment of the principal, along with the interest charges, is what defines an amortizing loan.
• Describe how the interest and principal components of an amortizing loan payment change over the life of the loan.
  • In an amortizing loan, the interest portion of each payment is highest at the beginning of the loan term and gradually decreases over time as the principal balance is paid down. Conversely, the principal portion of each payment increases over the life of the loan, as a larger share of the payment goes towards reducing the outstanding balance. This shift in the allocation between interest and principal is a key characteristic of amortizing loans and is reflected in the loan amortization schedule.
• Analyze the factors that influence the size of the periodic payments on an amortizing loan and how these factors impact the overall cost of the loan.
  • The two primary factors that influence the size of the periodic payments on an amortizing loan are the loan term and the interest rate. A longer loan term will result in smaller periodic payments, but the borrower will pay more in total interest over the life of the loan. Conversely, a shorter loan term will lead to higher periodic payments, but less total interest paid. The interest rate also plays a significant role, as a higher rate will increase the interest portion of each payment and the overall cost of the loan. The interplay of these factors determines the affordability and total cost of an amortizing loan for the borrower.

Related terms

Loan Amortization Schedule: A detailed table that shows the breakdown of each periodic payment on an amortizing loan, including the amount applied to principal and interest.

Balloon Payment: A large, final payment due at the end of a loan term, typically for loans that are not fully amortized over the life of the loan.

Annuity: A series of equal, periodic payments that are made or received over a set period of time, such as the regular payments on an amortizing loan.