Loan amortization refers to the process of paying off a loan through a series of regular payments over a set period of time. The payment of each installment includes both principal and interest, with the aim of gradually reducing the outstanding balance of the loan until it is fully repaid. The loan amortization pattern, or the way in which the loan is repaid, can have a significant impact on the overall cost of borrowing. Show There are several different types of loan amortization patterns, each with its own set of advantages and disadvantages. The most common types of loan amortization patterns include straight-line amortization, declining balance amortization, and constant payment mortgage (CPM) amortization. Straight-line amortization is the simplest form of loan amortization and involves dividing the total amount borrowed by the number of payments to be made, resulting in a fixed payment amount over the life of the loan. While this method is straightforward, it does not take into account the time value of money, meaning that borrowers end up paying more interest over time. Declining balance amortization involves calculating the interest owed based on the outstanding loan balance each period. This results in a decreasing payment amount over time, with the final payment equaling the outstanding loan balance. This method can result in lower total interest payments but may also lead to higher initial payment amounts. CPM amortization involves a fixed payment amount over the life of the loan, with the payment consisting of both principal and interest. The interest component of each payment decreases over time, while the principal component increases, resulting in a gradual reduction of the outstanding loan balance. This method can provide borrowers with predictable payments and can be particularly useful for those who plan to hold onto their property for a long time. When considering a loan, it is important to take into account the overall cost of borrowing, including interest rates, fees, and the loan amortization pattern. Additionally, understanding the terms of the loan, including any penalties for early repayment, can help borrowers make informed decisions. Practice Problems: Tom borrowed $100,000 at an interest rate of 5% per annum for a period of 20 years, with payments made monthly. Calculate the total interest paid over the life of the loan using straight-line amortization. Solution: Total interest paid = (Interest rate x Outstanding balance) / Number of payments Outstanding balance = Loan amount Interest paid in first quarter = 1% x 50,000 = $ Outstanding balance after first quarter = 50,750 - (750 - 1,000) = $ If you've borrowed money before, you're probably familiar with amortized loans. "Amortization" refers to the process of evenly spreading out a loan's payments over the length of the loan term. After you make your last required monthly payment, the loan is paid in full. Most consumer debt is made up of fully amortized loans, but partially amortized loans also exist. This is just as it sounds: The borrower pays off a portion of the debt with regular monthly payments, then makes a "balloon payment"—a large lump sum—on the loan maturity date. With partially amortized loans, only a portion of the full loan value is amortized, with a significant lump-sum payment due at the end of the loan's term. Key Takeaways
Commercial LendingPartially amortized loans are commonly found in certain business lending arrangements, such as commercial real estate. They allow the bank or financial institution to set a fixed interest rate for a certain time frame and can be an attractive option since the loan requires much lower monthly payments than would otherwise be possible. These reduced payments allow the project time to grow and appreciate or begin to earn revenue. This is beneficial for both the borrower and the lender. The borrower can make minimal payments while they wait for their cash flow to increase, and the lender doesn't have to take on significant duration risk. Longer loan terms have the real possibility of inflation, reducing the final maturity value of the collateral underlying the loan. NoteWhile partially amortized loans are most common in business lending, well-qualified individuals may be eligible for personal mortgages or home equity loans with similar payment structures. Risks of Partially Amortized LoansDespite their potential cash flow benefits, the biggest danger with taking on a partially amortized loan is almost always the massive repayment that is due at the end of the contract. No matter how stable or predictable your income is, no one knows what the future holds. If your finances take a turn for the worse, you could find yourself unable to pay off the balloon payment at the end of the loan. A common mistake people make is assuming they'll be able to refinance before that lump sum is due. But refinancing is not always available and if it is, it's not always available on economically acceptable terms. Partially amortized loans can also cost more than their fully amortized counterparts. Because you're making minimal payments until the very end of the loan, your loan principal will typically be larger over most of your loan term. This can mean higher interest charges over the life of your loan. NoteThere is also a non-amortizing loan, or "interest-only" loan as it is more frequently called. Most bond investments are structured this way. Here, the borrower will pay only the interest due each month. Upon maturity of the loan, the borrower has to pay the principal or get a new loan. Partially Amortized Loan vs. Fully Amortized LoanImagine you wanted to take on a $1,000,000 partially amortizing loan. You have a fixed interest rate of 8.5%. The bank agrees to give you a seven-year maturity with a 30-year amortization schedule. With these terms, your payment would be about $7,690 per month. You'll end up paying $576,678 in interest. At the end of seven years, you'll owe a lump sum of $938,480, and you must repay that entire amount or you'll default. If you default, the bank will seize the collateral and perhaps force you to declare bankruptcy, depending upon how the terms are structured. You'll end up repaying $1,576,678 in total. In contrast, if you had a traditional, fully amortizing loan with a seven-year maturity, you would pay $15,836 per month. You'll end up repaying $1,330,265, and at the end of the term, you'll owe nothing. While you make larger monthly payments with this model, you pay nearly $250,000 less in interest. Why Companies Use Partial AmortizationWhy would someone opt for the partially amortized loan in this situation? Despite the higher cost and the large balloon payment, the borrower got to enjoy more than $8,000 in spare cash each month as a result of the lower monthly payment. That could give the business project enough time to get off the ground or to sell whatever it was that the borrower was developing. In other cases, the underlying business growth might be sufficient to wipe out the loan's balance. For example, say a growing beverage company can't keep up with demand, so it borrows a partially amortized loan to build a much larger factory. That new factory allows the company to continue expanding and increase its income. By the time the balloon payment comes due, the company can easily afford it. |
