Loan amortization defined

Understanding a loan amortization is important before taking out a loan

The need for a loan is imposing the need for you to understand different aspects associated with any loan. There are things such as interest rate, collateral, cosigner, repayment period, monthly payments, early repayment, etc. stated in the agreement. How many of these items in your loan agreement do you really understand? Do you really read the loan agreement? Another important components you should understand are the loan amortization and loan amortization schedule.

Understanding the loan amortization and mortgage amortization respectively (although they are similar, if not the same) will be much easier if you are familiar with couple of things. Namely, before understanding anything related with loan amortization, you must comprehend the notion about what loan is and the different components of the loan.  Thus, beginning with the definition of a loan.

A loan can be defined as the process of giving money, or other material goods to another party expecting a future repayment of the principal amount plus any agreed interest and charges. Depending on the purpose, repayment period, and numerous other characteristics, there are different types of loans available. Some of the most common types of loans are: personal loans, car loans, revolving credit, and mortgage loans.

Components in loan amortization schedule

After briefly defining the meaning of loan, what follows is to go through the basic components of the loan some of which can be found in the loan amortization. They are:

  • Principal amount – your amortization schedule should clearly state the principal amount i.e. the loan amount you have been approved by the lender.
  • Interest rate – it shows the interest rate of your loan. If the lender is charging variable interest rate, then there might be different interest rates stated in the amortization schedule. If you have a variable interest rate loan, the interest rate can change during the loan life.
  • Annual percentage rate (APR) – as with the interest rate, amortization schedule should also state the APR. Make sure you understand the difference between interest rate and APR.
  • Outstanding debt (or outstanding balance) – as you make your monthly payments, the principal amount (amount you owe) will decrease. Thus, using your amortization schedule, you can see how much you owe to your lender (in terms remaining principal amount to be paid by you).
  • Loan maturity (repayment period) – the amortization schedule is also stating the length of your loan.
  • Monthly payment (sometimes referred to as installment) – is stated in your amortization schedule. In addition, there are separate columns for interest charge and principal repayment. You can see what portion of your monthly payments goes towards interest charges, and what portion goes toward repayment of the loan principal amount.

Additional components of the loan which will not be on the amortization schedule are:

  • Collateral – can be any type of asset serving the purpose to guaranteeing on time loan repayment. In case of borrowers defaulting on the loan, the collateral will be seized by the bank (lender).
  • Loan cosigner – is providing guarantee for the bank that the original borrower will pay back the loan. If for whatever reason the borrower stops paying its monthly obligation, then the obligation is transferred to the cosigner. This is how banks will protect themselves against non-repayment of their money.

After going through the components above, it is time to understand what is actually a loan amortization?

What is mortgage or loan amortization?

Amortization (amortizing loan) in banking terms is representing the process of repaying the principal amount of the loan, in accordance to an amortization schedule. The repayment is commonly performed through equal payments and regular payments, such as monthly payments.

Loan amortization schedule defined

Amortization schedule is yet another term that you should be familiar with. It represents a method for providing an overview of your repayment process. It could be said that the amortization schedule is basically a loan repayment schedule, in the form of a table. This table is giving an overview of the loan repayment by breaking down the schedule of all loan payments, during the loan life.

The amortization schedule can be highly useful document as long as you know how to read it and use it. It provides all the relevant information you need to know in relation to your loan and/or mortgage.  From the amortization schedule every borrower is able to see the following:

  • The overall cost of the loan – because the schedule is listing the total interest you will pay during the lifetime of your loan.
  • You can see the terms such as: interest rate, repayment period, when monthly payments are due, etc.
  • Remaining principal amount to be paid, at some point after you started paying your monthly payments.

Amortization schedule can also come in handy when trying to compare loans offered by different lenders. Because of the components it takes into account, you can make in-depth comparison of the loans. Stated differently, mortgage amortization or loan amortization schedule can come in handy when looking to refinance your existing debt. This is so because you could make a comparison about the full cost of loan before deciding to go with the refinancing option.

In general the term amortization refers to a situation where the principal amount owed is repaid through installments in accordance to a pre-defined schedule. Thus, the mortgage amortization is providing information about the payment obligation. Meaning that, it is a schedule with the aim of providing insights into the disbursement of monthly payments in adequate portions. Stated differently. The schedule determines the portion of the installment that will be assigned toward interest payment and the portion that will be assigned toward principal payment.

Fixed rate loan and adjustable rate loan

There are some basic differences on the amortization schedule for a fixed rate loan and adjustable rate loan. A fixed rate mortgage is characterized by a regular and equal payments amortization in accordance to a predefined schedule. For instance, on a 25 year fixed rate mortgage, you are going to pay equal (same) amount every month until the end of the mortgage term i.e. full repayment. On the other hand, the amount of your monthly payments will change (upward or downward) if you have an adjustable rate mortgage. The change in the amount of monthly payments is induced by the changes in the market interest rates, or changes in the benchmark interest rates.

Most lenders offer fixed interest rate for the first couple of years of the loan life, afterwards, the interest rate is adjustable in accordance to the agreement terms. This means that, your amortization schedule will show you different monthly payments for the fixed interest rate period and adjustable rate period.

The amortization schedule can come in handy if you want to see the remaining balance of principal amount to be repaid. In addition, loan amortization schedule offers easy way to see the equity you have in your property (when talking about mortgage loans). That is, not considering the market value. Then the equity can be much higher or lower, depending on the changes in property prices in between. Namely, you can see how much of the principal amount has been repaid. This comes in handy because, as it was mentioned, from your payments at the beginning of the loan life, big portion goes toward interest rate. As payments are accumulated, the interest rate portion is decreasing over time, and the principal amount is increasing.