An amortized loan is a loan in which the borrower repays both the principal and interest through regular, fixed payments over a specified period. Each payment consists of a portion that goes toward interest and a portion that reduces the loan principal.
Over time, as the principal decreases, the interest portion of the payment reduces, and a larger portion goes toward the principal. This type of loan structure is common in mortgages, auto loans, and personal loans. Amortized loans offer predictable payments and a clear timeline for fully paying off the debt, making them manageable and transparent for borrowers.
How it Works:
An amortized loan works by splitting each loan payment into two parts: one part goes toward repaying the loan’s principal, and the other part covers the interest. Over time, as more of the principal is paid off, the interest portion of each payment decreases, and more of each payment goes toward reducing the principal.
Initial Payments: At the beginning of the loan term, most of the payment covers interest because the outstanding loan balance (principal) is still high. A smaller portion reduces the principal.
Declining Interest: As the loan progresses, the outstanding principal reduces with each payment. Since interest is calculated based on the remaining principal, the interest portion of the payment gradually decreases.
Increasing Principal Payments: With each payment, as the interest portion decreases, more of the payment goes toward reducing the principal.
Fixed Payments: The borrower makes regular, fixed payments throughout the term of the loan. Although the payment amount stays the same, the allocation between interest and principal changes over time.
Example:
In a 30-year mortgage, early payments are primarily interest. As time goes on, the principal is paid down, and by the end of the loan, most of the payment is applied to the principal. This ensures that the loan is fully paid off by the end of the term.
Key Features of an Amortized Loan:
- Fixed Payment Schedule: Regular payments (monthly, quarterly, etc.) are made over a set period.
- Interest and Principal: Each payment consists of both interest and a portion of the loan principal.
- Declining Interest: As the principal balance reduces with each payment, the interest amount decreases over time.
- Loan Types: Amortized loans include mortgages, auto loans, and personal loans.
Amortization Formula:
The loan payment can be calculated using the amortization formula:
M= P× (1+r) n / (1+r)n−1
- M = Monthly payment
- P = Loan principal (initial loan amount)
- r = Monthly interest rate (annual rate / 12)
- n = Total number of payments (loan term in months)
