Loan amortization gives customers a crystal clear picture of the amount they are expected to repay in the course of each repayment cycle.
Borrowers will have a flat repayment plan during the entire period of repaying their loan.
Repayments are expected
Some well-known amortized loans are car loans, home mortgages, and student loans.
How does loan amortization works?
Once you have an amortized loan, your ratio of principal to interest will not remain the same during the course of the scheduled repayment period.
The variation in principal and interest is documented in an amortization schedule.
The total amount attached to interest will typically be higher at the start of the repayment period and will decline as time goes on.
Similarly, the amount attached to the principal will be less at the beginning of the repayment period and will rise towards the end.
In contrast, an unamortized loan, will include interest-only payments during most of the repayment period and round off with a balloon payment for what is left in the principal.
For instance, a business borrows $10,000 for a one year term at an annual percentage rate of 5 percent.
If the business decides to start repayment in the first month, its payment would remain constant at $856.07.
This amount will remain unchanged in the course of the twelve payments throughout the agreed repayment period.
However, the amount of money that is assigned to the principal and the interest will gradually change.
As such, the business first interest payment will be $41.67, while the last interest payment should be $3.55.
The business first principal payment should be $814.40. Also, the business last principal payment will be $852.52.
Despite the variation in the principal and interest rates, the business is expected to regularly pay $856.07 during the course of the loan’s lifespan.
The Difference between Amortized and Unamortized Loans
Generally, amortized loans are more common and favorable for most borrowers.
However, the decision to seek an amortized loan will be based on your precise situation.
Due to the fact that an amortized loan makes it possible for borrowers to repay both principal and interest simultaneously, borrowers gain equity in the asset.
The equity could be a car or even a house, with every payment.
Furthermore, borrowers know exactly how much they will be paying each month since the rate is constant.
Once you’re aware that your payment is constant from month to month, your financial planning process will be easier and efficient.
However, one of the key things you’ll have to bear in mind is that the amount you’ll be paying every month may be high because your payment will include both principal and interest.
Another setback to amortized loans is that many borrowers do not have information about the actual cost of the loan.
You shouldn’t obtain a loan just because the repayment
Some borrowers prefer unamortized loan because of its lower interest-only repayment plan.
While borrowers are not required to pay any principal at the beginning (as a result they won’t gain equity), unamortized loans offers low affordable repayments until borrowers have enough cash to make a huge payment.
Unamortized loans are more suitable for individuals who receive periodic lump-sum payments, like individuals who depend on bonuses, commission etc. such as a contractor or a real estate agent.
Also, unamortized loans are more direct because every monthly payment is only used for interest.
As such, borrowers can easily calculate the actual cost of the loan.
However, the benefit of lower interest rates also changes towards the end of the repayment period.
Borrowers are required to have a balloon payment that will be used up for principal.
As such, having an effective plan ahead, can help you prepare appropriately to avoid being delinquent as a result of the change in payment.
Being aware of the amount you will pay every month and the total amount of interest you will pay is crucial when considering a loan.
Having such details will help you figure out if the cost of the loan is truly worth what you need it for or not.