Loan amortization is where the principal of the loan is paid down over the life of the loan (it is amortized) according to an amortization schedule, typically through equal payments. Each payment consists of a portion of the interest and a portion of principal.
The “principal” is the initial amount of the debt, while the “interest” is the amount you pay for the use of someone else’s money. It is expressed as a percentage.
The interest component of each payment will decrease while the principal component decreases during the life of the loan. As the loan is paid off, a progressively larger portion of the payments goes towards the principal and a progressively smaller portion towards the interest.
The word “amortizing” has its roots in the French term “amortir” which refers to the act of providing death to something. Amortization is therefore the elimination of a debt over time with periodic payments.
There are two types of loan amortization, namely: fully amortized and partially amortized.
Fully amortized loans:
With these loans, when you pay the instalment the debt balance is reduced and the interest due on the next payment is recalculated based on the new (reduced) loan principal balance.
An example of this type of loan is a mortgage loan.
Partially amortized loans:
These loans are partially amortized when instalments are not enough to repay the initial loan principal by the end of the term.
An example of this type of loan is a balloon payment on a vehicle finance arrangement.
Interest payments are much higher at the beginning of a loan, with more going towards payment of the principal amount as the loan nears maturity.
What is a loan amortization schedule?
This is a schedule that outlines how repayment will occur if payments are made on time and in the proper amounts. This schedule shows each payment on one line and how the payment is applied to the loan.
With loan amortization, the shorter the remaining term, the larger the increase required to amortize the loan over this period.