Whenever applying for a loan, it’s essential to familiarize yourself with the terminologies that come with the process.
Terms like “fully amortized loan,” for example, determine the method through which your loan will be repaid and, as such, your actual debt liability.
Loans such as mortgages and home equity loans are structured so that the borrower pays off both the principal and the interest during the loan term.
The ratio at which you pay down these two parts individually determines how long you will be paying off that loan and how expensive it is.
Fully amortized loans are the most common type of loans available today. Let’s take a quick look at what this means and how it affects your repayment plan.
What is a Fully Amortized Loan?
A fully amortized loan has scheduled payments covering the principal and interest accrued within a specific loan term.
This type of loan is designed to first pay off the interest accrued for the entire loan term. Once that figure is reached, the remaining funds are channeled toward paying the principal.
The most common types of amortized loans include:
- Home loans
- Mortgages
- Auto loans
- Personal bank loans
How Amortized Loans Work
The interest accrued on an amortized loan is calculated according to the most recent balance of the loan amount. That means the interest payment amount changes based on the remaining loan principal. As such, the more you pay down the loan’s principal, the less interest accrued.
The trick with amortized loans is that the payments you make pay off the interest accrued within that period first. Anything above and beyond that interest amount goes toward paying down the principal. This, in turn, reduces the loan balance on which the interest accrued is calculated.
The more you pay down the interest and channel more money toward reducing the principal, the lower the interest you accrue.
Technically, this means that the more the interest portion on your amortized loan decreases, the more money you have to pay down the principal, the more the interest accrued reduces, and so on.
This gives the two portions of your loan (interest accrued and principal) an inverse relationship over the loan’s full term.
Understanding a Loan Amortization Schedule
Whenever you, as a borrower, take out a loan, you have options as to which kind of monthly payment rate you will agree to.
Typical loans, such as auto loans and mortgages, offer you a fixed rate. This means that your repayment term is set, and as such, you will receive a loan amortization schedule that will lay out your payments for the course of the loan and how much you need to pay per month.
With this loan amortization schedule, you can calculate how much interest you will have paid on the principal by the end of your loan term.
There’s one significant advantage that comes with understanding this loan amortization schedule.
It gives the necessary information about your loan. It puts you in a better position to make strategic moves like making an extra monthly payment to pay the principal faster.
How Does a Loan Amortization Schedule Work for Fully Amortized Loans?
This schedule is designed to give you the most basic information about your amortized loan. It has a clear list of all the required payments over the loan term.
It also includes a breakdown of how the repayments will work, how much money goes toward the interest, and how much goes toward the principal.
Finally, it includes the remaining balance after each payment period, which means you can see how much total debt you still have after specific periods.
The schedule also includes how much you have already paid towards servicing the loan. This is often included at the bottom or on a completely separate sheet.
How Do You Calculate a Fully Amortized Loan?
Calculating the repayments you need to make on your fully amortized loan isn’t as complicated as you may think. The good thing is that your lender will provide you with this information anyway.
However, if you are keen on verifying their math, here is what you need to do:
- Start on month one and multiply the total amount of the loan by the stated interest rate
- If you intend to make monthly repayments, take the result, and divide it by 12 to get the total interest you will be paying monthly.
- If you have a loan amortization schedule, you will notice a specific amount you must pay monthly. Subtract the monthly payment interest from this amount to get the money that will be going towards paying down the principal every month
- Moving to month two, you need to do the same thing, only this time, the total amount of the loan will be less the amount you will have paid towards the principal in month one instead of the original figure you had.
- Do this for the rest of the 10 months, and if your math is correct, you should have a principal balance of zero by the end of the loan term.
What’s the Difference Between a Fully Amortized Loan and a Partially Amortized Loan?
The two main types of loans are fully amortized and partially amortized. The biggest difference between these two is that with a fully amortized loan, you must make a monthly payment as per the loan amortization schedule given to you by your lender.
If you stick to the schedule, you will have paid off your loan by the end of the term.
On the other hand, a partially amortized loan has different periods where an amortization schedule is applied and other periods where there’s no amortization schedule used.
These loans are typically paid over a much longer period (think 7 to 9 years). In this case, the borrower will be required to pay off the remaining balance at the end of the amortization period.
With the right kind of financial discipline, a fully amortized loan is much easier to pay down due to the nature of its repayment schedule and structure.