An amortizing loan or amortized loan is one with scheduled regular payments of both principal and interest. The principal of a loan is the amount originally borrowed, while the interest is what the lender adds on top.
An amortizing loan contrasts with other forms of lending where the principal is either paid later on, or at the end of the term, as with a balloon loan.
With a totally amortizing loan the payments usually stay the same until the debt is paid off. A partially amortized loan may have a large balloon-type payment at the end.
When arranging an amortizing loan, the lender will calculate how much the borrower will have to pay back in total – the principal plus the interest. That total will be divided by a set number of payments.
The payment schedule is called an ‘amortization schedule’.
Imagine you want to borrow $10,000 to buy a car, the lender charges an annual interest rate of 10%, and you have to pay back over a period of one year, i.e. twelve payments. The principal is $10,000, plus $1,000 in interest, which equals $11,000. If the lender calculated monthly, you will have to make 12 monthly payments of $916.66.
When borrowers look at the amortization schedule, they may notice that the monthly payments are not all the same. This is because the lender probably divided the total by the number of days, and then multiplied that amount by the number of days in each month (months have different number of days).
In most mortgages, which can be thirty years long, the borrower starts by paying off a higher proportion of interest than principal, while toward the end it is the other way round, even though each installment throughout the term is the same amount.
Amortizing loan less risky for the lender
As far as the lender is concerned, an amortizing loan is less risky. With loans where the principal is paid at the end or later on, the lender is exposed to a credit risk for the full principal during most of the term.
By paying off the principal over time, the risk is lower.
With an amortizing loan, the borrower will not experience a payment shock later on. With a balloon loan, for example, there is a risk the borrower will not be able to pay the huge installment that falls at the end of the term.
Video – Loan Amortization