Amortizing loan – definition and meaning
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 the borrower borrowed originally. The interest, on the other hand, is what the lender adds on top.
An amortizing loan contrasts with other forms of lending. In this type of loan, the borrower pays the principal either later on or at the end of the term. For example, with a balloon loan or bullet loan, there is a huge payment at the end.
With a totally amortizing loan, the payments usually stay the same until the borrower pays off the debt. 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 total is the principal plus the interest. The lender divides that total by a set number of payments. We call this payment schedule 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 therefore equals a total payment of $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. They vary 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 a different number of days.
Mortgages are usually long-term loans – they can be thirty years long. The borrower starts by paying off a higher proportion of interest than principal. However, toward the end, it is the other way round. Even though each installment is identical, the borrower pays off different parts of mortgage during the term.
Amortizing loan less risky for the lender
As far as the lender is concerned, an amortizing loan is less risky. With loans where the borrower pays the principal at the end, the lender has a longer credit risk. The lender’s risk in such cases is for the full principal during most of the term.
By paying off the principal over time, the risk is lower for the lender.
With an amortizing loan, the borrower will not experience a payment shock later on. With a balloon loan, for example, the borrower might default when the huge payment is due at the end.
“An amortizing loan is a loan where the principal of the loan is paid down over the life of the loan (that is, amortized) according to an amortization schedule, typically through equal payments.”