What is Loan Amortization and How It Works

Knowing the amount you owe and its term is the key to managing your finances better. Loan amortization is a way to find that information. Just like your car’s value reduces over time and usage, the obligations will also decrease as you make the repayments. Read on to better understand what amortized loans are and how amortization works.

What is an Amortization Loan?

An amortized loan is a type of financing you pay off over a specific period. It is a repayment structure where your repayment amount remains the same throughout the tenure, with the first few repayments going towards the payable interest and the later repayments against the outstanding principal balance. Although loan amortization determines the minimum repayment to pay each month, it does not limit the additional payments you can make. Extra payments go towards the principal, helping you save money on the interest cost.

What are the Types of Amortising Loans?

Loan amortization encompasses installment loans that require a monthly repayment amount, where each Equated Monthly Installment (EMI) consists of the principal and the interest amount. It divides a fixed-rate amortized loan into equal repayments, with each payment encompassing a certain percentage of the principal balance and payable interest. Some common types of amortizing loans include Personal Loans, car loans, education loans, home equity loans, and fixed-rate mortgage loans, among others.

Amortised Loans vs Balloon Loans vs Revolving Debt (Credit Cards)

While looking for an amortized loan, you may come across terms like balloon loans and revolving debt. Understanding their distinctions clearly is essential before signing up for one:

Amortised Loans

Now that you understand what an amortization loan is, you know it involves an equal EMI repayment over a specific period. Each EMI consists of a certain percentage of the interest and the principal amount. As you advance in the repayment term, the interest component decreases, and principal repayment increases.

Balloon Loans

These are relatively shorter-term loans with only a portion of the principal repayment amortized over the term. You must pay the remaining balance as a final repayment at the term's end.

Revolving Debt (Credit Cards)

Revolving debt gives you a credit limit up to which you can borrow as and when needed, such as credit cards. You repay what you borrow with interest. There are no EMIs or fixed repayment amounts in revolving debt.

How Does a Fully Amortized Loan Work?

A fully amortized loan has a complete breakup of the loan balance into a repayment schedule based on the loan term, interest rate, and principal amount. When you apply for a Personal Loan, an amortization schedule helps you see how much principal and interest you will pay as part of EMI and know the remaining balance after each repayment.

The interest amount depends on the last ending loan balance, and it decreases as you make your repayments. That is because any excess payment other than the interest amount reduces your principal balance, decreasing the balance on which your i nterest will depend. As the interest part decreases, the principal portion for your amortized loan increases during the loan term.

How to Amortize Loans?

Do you want to create a schedule for your amortized loan? Follow these steps to make the calculations:

Finding the Principal Amount, Repayment Tenure, and Interest Rate: The first step is gathering the variables from loan information. The principal is the loan amount you borrow from the loan provider. Don't include the payments you have already made on the loan. The interest rate must be available in your loan document, or use the interest rate the lender offers. Convert the annual interest rate into a monthly rate. The last variable is the number of months in the loan tenure.

Creating an Amortization Table: Create a table including four columns, namely month, principal, monthly interest payment, and principal payment. Under the month heading, create rows for the number of months in the loan tenure. For instance, if you take a Personal Loan for two years, you will need 24 rows. Make this table on a spreadsheet and utilize its equation feature.

Calculating the Principal and Interest Cost of Your First EMI: Enter the amount you borrowed as the principal under the 'Principal' header. Next, input the interest cost for the first month under the Monthly Interest Payment' section. To determine the principal payment, subtract the interest component from your EMI amount, and record it under the 'Principal Payment' header. In the case of an amortized loan, the fixed EMIs simplify the calculation of the percentage of principal and interest components.

Calculating the Principal and Interest Cost of Your Next EMIs: Subtract the first EMI amount from the total principal to calculate the principal amount for the next month. Continue performing these calculations for the next months during the loan period. As the principal amount decreases, the interest payment also declines. The reducing principal shows your loan amortization.

Monitoring the Payment Trends: Monitoring the payments will help make better financial choices. For instance, if you have surplus funds to pay off your debts, examine the amortization schedule to determine which highest-interest loan plan. Pay off the highest-interest loans first to reduce the debt burden.

What is an Amortized Loan Table?

An amortized loan table helps understand the amortization schedule. It lists each EMI payment and divides each EMI into interest and principal components. A Personal Loan calculator can create this table and get the desired information. A fully amortized loan table contains the following information:

• Scheduled Payments: It lists your monthly payments by month for the entire loan tenure.
• Principal Repayment: After applying the interest cost, the remaining payment goes towards the principal repayment.
• Interest Cost: Each scheduled EMI contains a portion of your interest cost. You can calculate it by multiplying your outstanding loan amount by your monthly rate of interest.

Although the EMI amount remains the same throughout the loan term, the percentage of principal and interest contribution changes as you move forward in the tenure. The initial stages of the term contribute more towards the interest, while the later EMIs contribute more towards the principal. An amortized loan table clearly describes this proportion.

Example of an Amortization Loan Table

Loan amortization is a way to apply loan payments to some loan types. Typically, the EMIs remain the same and contain a certain percentage of the interest cost, loan balance, and other expenses like taxes. For instance, if you borrow a Rs 1,50,000 Personal Loan with a 12% interest rate and amortize it over two years, your monthly EMI amount will be Rs 7,061. If you don't make any additional payments, you will pay a total of Rs 1,69,465, including the total interest cost of Rs 19,465.

Payment Number	EMI (Rs)	Principal Payment (Rs)	Interest Payment (Rs)	Remaining Balance (Rs)
1	7061	5561	1500	144439
2	7061	5616	1444	138822
3	7061	5672	1388	133149
4	7061	5729	1331	127420
5	7061	5786	1274	121633

Conclusion

Loan amortization spreads out the repayment into fixed EMIs, helping you understand how your repayments will apply during the loan tenure. A portion of each EMI goes differently towards the interest and principal balance during various term stages. Create a fully amortized loan table using a Personal Loan calculator and plan your repayment better.

Frequently Asked Questions

1. What does it mean if a loan is amortized?

A loan is amortized means that its total due amount is split into fixed equal installments consisting of both the principal amount and the interest cost.

2. What are three different methods of amortization?

The three methods of loan amortization are-

1. Progressive method
2. Increasing balance method
3. Declining balance method

3. What is the difference between a loan and an amortized loan?

An amortized loan has its principal payments spread out over the loan term, meaning that each EMI consists of the principal and the interest amount. On the other hand, in an unamortized loan, you have to pay interest during the loan term and make a balloon payment for the principal amount in the end.