8.3 Loan Amortization
3 min read•june 18, 2024
Loans come in two main flavors: amortizing and non-amortizing. , like mortgages, have fixed payments that cover both and . , such as , only require interest payments until a big payment at the end.
spreads payments over time, with each installment covering principal and interest. Early on, more of each payment goes to interest. As the loan progresses, more goes to principal. Understanding amortization helps borrowers grasp their and compare loan options.
Loan Types and Amortization
Types of loans: amortizing vs non-amortizing
Top images from around the web for Types of loans: amortizing vs non-amortizing
2.3 Functions for Personal Finance – Beginning to Intermediate Excel View original
Is this image relevant?
U.S. Financial Institutions | OpenStax Intro to Business View original
Is this image relevant?
Loan Amortization - Finance image View original
Is this image relevant?
2.3 Functions for Personal Finance – Beginning to Intermediate Excel View original
Is this image relevant?
U.S. Financial Institutions | OpenStax Intro to Business View original
Is this image relevant?
1 of 3
Top images from around the web for Types of loans: amortizing vs non-amortizing
2.3 Functions for Personal Finance – Beginning to Intermediate Excel View original
Is this image relevant?
U.S. Financial Institutions | OpenStax Intro to Business View original
Is this image relevant?
Loan Amortization - Finance image View original
Is this image relevant?
2.3 Functions for Personal Finance – Beginning to Intermediate Excel View original
Is this image relevant?
U.S. Financial Institutions | OpenStax Intro to Business View original
Is this image relevant?
1 of 3
- Amortizing loans require periodic payments that include both principal and interest, with the payment amount remaining constant throughout the (mortgages, auto loans, )
- Over time, the portion of each payment allocated to principal increases, while the interest portion decreases
- Non-amortizing loans involve principal being paid in a lump sum at the end of the loan term, with periodic payments consisting of interest only (, balloon loans, )
- Amortizing loans typically have lower periodic payments but result in higher total interest paid over the life of the loan compared to non-amortizing loans
- Non-amortizing loans have lower total interest paid but require a large principal payment at the end of the term
Process of loan amortization
- spreads out loan payments into fixed installments over a specified period, with each payment consisting of both principal (original amount borrowed) and interest (cost of borrowing)
- Early in the loan term, a larger portion of each payment is allocated to interest due to the remaining principal balance being highest at the beginning
- As the loan progresses and the remaining principal balance decreases with each payment, a larger portion of each payment is allocated to principal, resulting in less interest charged
- The loan term (duration of the loan) affects the total amount of interest paid and the size of periodic payments
Construction of amortization schedules
- An shows the breakdown of each loan payment into principal and interest, as well as the remaining loan balance after each payment
- To create an amortization schedule using spreadsheet software:
- Input loan details such as principal amount, interest rate, and loan term
- Use the formula to calculate the amount, where is the principal loan amount, is the periodic interest rate, and is the total number of payments
- For each payment period, calculate the interest portion ( from previous period * periodic interest rate), principal portion (fixed periodic payment - interest portion), and remaining balance (previous remaining balance - principal portion)
- The amortization schedule helps borrowers understand their debt service (total amount paid in principal and interest) over time
Analysis of total borrowing costs
- includes interest expenses (sum of interest portion of each payment from amortization schedule) and fees (, , ) over the life of the loan
- Higher interest rates and longer loan terms result in higher total interest expenses
- When comparing loan options, consider that shorter loan terms generally have higher periodic payments but lower total interest expenses
- provide predictable payments, while may have lower initial payments but carry the risk of higher future payments if interest rates rise
Time Value of Money and Loan Calculations
- The concept is fundamental to understanding loan calculations and amortization
- is used in loan calculations, where interest is earned on both the principal and previously accumulated interest
- calculations are used to determine the current worth of future loan payments, helping in loan comparisons and decision-making
Key Terms to Review (35)
Adjustable-Rate Loans: Adjustable-rate loans, also known as variable-rate loans, are a type of loan where the interest rate fluctuates over the life of the loan. The interest rate is tied to an index, such as the prime rate or LIBOR, and can change periodically, usually monthly or annually, based on market conditions.
Amortization Schedule: An amortization schedule is a table that outlines the periodic payments, interest, and principal components of a loan over the life of the loan. It is a critical tool for understanding the long-term financial implications of a loan and managing debt repayment effectively.
Amortizing Loans: 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.
Balloon Loans: A balloon loan is a type of loan where the majority of the principal is due in a single lump sum payment at the end of the loan term, rather than being amortized over the life of the loan. This structure results in lower monthly payments throughout most of the loan period, but a large final payment that the borrower must be prepared to make.
Bullet Loans: A bullet loan is a type of loan where the principal amount is repaid in a single lump-sum payment at the end of the loan term, rather than through a series of regular installment payments. These loans are commonly used for short-term financing needs and often have a higher interest rate compared to traditional amortizing loans.
Closing Costs: Closing costs are the fees and expenses associated with the purchase or refinancing of a home. These costs are paid at the time of the real estate transaction and include a variety of charges from different parties involved in the process.
Compound Interest: Compound interest is the interest earned on interest, where the interest accumulated on the principal balance of an investment or loan is added to the principal, and the resulting sum then earns additional interest. This process of earning interest on interest creates exponential growth over time, making compound interest a powerful concept in finance.
Debt Service: Debt service refers to the periodic payments required to repay the principal and interest on a loan or other debt obligation. It is a critical component of loan amortization, which is the process of gradually paying off a loan over time through a series of scheduled payments.
Equifax: Equifax is one of the three major credit reporting agencies in the United States that collects and maintains consumer credit information. It provides credit reports and scores that lenders use to assess an individual's creditworthiness for loans and other financial products.
Experian: Experian is one of the three major credit reporting agencies that collect and maintain consumer credit information. They provide credit reports, which are crucial for assessing loan applications and determining interest rates.
Fixed Periodic Payment: A fixed periodic payment refers to a set amount that must be paid at regular intervals, such as monthly or yearly, for the duration of a financial obligation or agreement. This term is particularly relevant in the context of loan amortization, where the borrower makes consistent payments to gradually pay off the principal and interest of a loan over time.
Fixed-Rate Loans: A fixed-rate loan is a type of loan where the interest rate remains constant throughout the entire repayment period, regardless of changes in market conditions. This ensures that the borrower's monthly payments remain the same, providing predictability and stability in their financial planning.
Interest: Interest is the cost of borrowing money, expressed as a percentage of the principal amount. It represents the compensation a lender receives for the use of their funds over a specific period of time. Interest is a fundamental concept in the context of loan amortization, as it directly impacts the overall cost and repayment schedule of a loan.
Interest-Only Loans: An interest-only loan is a type of loan where the borrower is required to pay only the interest charges on the loan for a specified period of time, with no payments towards the principal balance. This type of loan is often used for real estate investments or to temporarily lower monthly payments.
Loan amortization: Loan amortization is the process of gradually paying off a loan through scheduled, pre-determined payments that include both principal and interest. The payment amounts are designed to fully repay the loan by the end of its term.
Loan Amortization: Loan amortization is the process of gradually paying off a loan over time through a series of scheduled, equal payments. It involves the systematic reduction of the loan balance by allocating each payment towards both the principal and interest components of the loan.
Loan Term: The loan term refers to the length of time over which a loan must be repaid. It is a crucial aspect of loan amortization, as it determines the duration of the repayment period and the overall cost of the loan to the borrower.
Mortgage loan: A mortgage loan is a type of loan used to purchase real estate, where the property itself serves as collateral. Borrowers repay the loan through regular installments over a set period, typically including both principal and interest.
Non-Amortizing Loans: A non-amortizing loan is a type of loan where the borrower is not required to make regular payments towards the principal balance of the loan. Instead, the borrower only makes payments on the interest accrued, leaving the original loan amount intact until the end of the loan term.
Origination Fees: Origination fees are charges imposed by lenders when a loan is initiated or originated. These fees cover the administrative costs associated with processing and underwriting a loan application, and are typically paid by the borrower at the time of loan closing.
Personal lines of credit: A personal line of credit is a flexible loan from a financial institution that allows you to borrow up to a predetermined limit. It is typically used for short-term funding needs and can be accessed as revolving credit or a fixed term.
Prepayment Penalties: Prepayment penalties are fees charged by lenders when a borrower pays off a loan or mortgage before the scheduled end of the loan term. These penalties are designed to compensate the lender for the lost interest income they would have earned had the loan been paid off as originally agreed.
Present Value: Present value is a fundamental concept in finance that refers to the current worth of a future sum of money or stream of cash flows, discounted at an appropriate rate of interest. It is a crucial tool for evaluating the time value of money and making informed financial decisions across various topics in finance.
Principal: The principal is the owner or shareholder in a corporation who delegates authority to agents (managers) to act on their behalf. Principals invest capital and expect returns, while ensuring that their interests are represented in corporate decisions.
Principal: The principal is the original amount of money borrowed or invested, excluding any interest or other charges. It is the core value upon which financial calculations and transactions are based, playing a crucial role in understanding loan amortization and the characteristics of bonds.
Remaining Balance: The remaining balance is the unpaid portion of a loan or debt that continues to be owed after each scheduled payment is made. It represents the outstanding amount that the borrower still needs to pay off to fully satisfy the loan agreement.
Revolving lines of credit (revolvers): Revolving lines of credit (revolvers) are flexible financing options that allow borrowers to draw, repay, and redraw funds up to a set credit limit. Unlike installment loans, they do not require fixed monthly payments or a specific repayment schedule.
Secured personal loan: A secured personal loan is a type of loan where the borrower pledges an asset as collateral, such as a car or savings account. If the borrower defaults on the loan, the lender can seize the collateral to recover the owed amount.
Student loans: Student loans are funds borrowed to pay for educational expenses, which must be repaid with interest. They often have varying terms and conditions based on the type of loan and lender.
Term loans: Term loans are a type of loan with a specified repayment schedule and a fixed or variable interest rate. They are typically paid off in regular installments over a set period of time, such as monthly or quarterly payments.
Time Value of Money: The time value of money is a fundamental concept in finance that recognizes the difference in value between a sum of money available today and the same sum available at a future point in time. It is based on the principle that money available at the present time is worth more than the identical sum in the future due to its potential to earn interest or be invested to generate a return.
Time value of money (TVM): Time Value of Money (TVM) is the concept that money available now is worth more than the same amount in the future due to its potential earning capacity. This principle underlines why receiving money today is preferable to receiving it later.
Total Cost of Borrowing: The total cost of borrowing refers to the cumulative expenses incurred by an individual or entity when taking out a loan. It encompasses not only the principal amount borrowed but also the interest, fees, and any other associated charges over the life of the loan. This concept is particularly relevant in the context of loan amortization, where the total cost of borrowing is a critical factor in understanding the overall financial implications of a loan.
TransUnion: TransUnion is one of the three major credit reporting agencies in the United States. It provides credit information and analytics to help businesses and consumers make informed financial decisions.
Unsecured personal loan: An unsecured personal loan is a type of loan that does not require collateral, meaning the borrower is not required to pledge assets to secure the loan. Approval and interest rates are based on the borrower's creditworthiness and financial history.