The money loaning and repayment system is complicated and appears in a variety of forms, particularly when borrowing large sums of money. This resulted in the creation of loan amortization, which provides a fixed payment amount at specified intervals. These predetermined payments cover both the principal and the interest on the loan and serve to clarify the situation. This article simplifies loan amortization for your comprehension, in addition to covering everything else you need to know.

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What is loan amortization?

Loan amortization is a form of loan with a repayment structure based on a schedule. This structure requires the borrower to make periodic payments, and it pertains to both the loan's accrued interest and principal balance. The purpose of an amortized loan is to pay off accrued interest for a specified period of time, and then either to pay off the principal or both at once.

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In simpler terms, it amortizes any loan with a repayment schedule consisting of interest and principal. Examples include auto or vehicle loans, personal bank loans, mortgages, etc.

How does loan amortization work?

The loan amortization system is pretty  complex but straightforward to comprehend if followed precisely.

To determine the interest rate on an amortized loan, the most recent loan balance is utilized. In this manner, the interest payment fluctuates based on your ability to make periodic payments. At the specified intervals, excess payments reduce the principal by the amount of the excess payment. This reduces the remaining balance, which is used to calculate future interest.

This system encourages you to make overpayments, which reduce the loan's principal after accounting for accrued interest. This results in a lower rate of interest, as the interest is calculated periodically based on the most recent loan balance. The interest and principal on an amortized loan have an inverse relationship over the term of the loan.

Why amortize a loan?

The purpose of loan amortization is to provide the borrower with a distinct picture to work with. They design it so that you can repay the loan in equal quantities over an extended period of time. However, you can accelerate the process by paying more, thereby reducing the principal balance. In this manner, both the interest and principal are paid off simultaneously. If you decide to concentrate solely on the interest payment, the principal balance will increase and vice versa. This system facilitates simultaneous payment to both parties.

What are the types of loan amortization?

The amortization of a loan can fall into any of the four categories. The following are:

Full amortization: 

in this loan, paying the complete amortization would result in your outstanding balance being reduced to zero at the end of the loan term. This is the most common loan amortization type.

Partial amortization: 

This requires you to pay a portion of your amortization. For each monthly payment, the loan's outstanding principal balance would be reduced. If only partial payments are made, there will be an outstanding balance at the end of the loan term.

Interest only: 

For an interest-only loan, you would not include any amortization installments. It concentrates on paying only interest, and the principal balance remains unchanged at the end of the term.

Negative amortization: 

Negative amortization is less expensive in the immediate term but more expensive in the long-term. This form of loan requires lower monthly payments than interest-only loans, but each payment increases the principal balance. At the conclusion of each month, any shortfall in interest payments is added to the total amount due on the loan.

Loan amortization – practical example

Putting the four categories of loan amortization into context, assume that you borrowed N300,000 with a 20-year repayment schedule.

With complete amortization, the loan would be paid off after twenty years. If partial amortization is applied, you may still incur some amount at the end of the term, but it will be significantly less than N300,000. With only interest, you would have repaid the interest, but the N300,000 principal balance remains. Negative amortization would likely result in increased debt at the conclusion of the loan term.

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Conclusion

Loan amortization is a transparent system that provides a plain repayment strategy. It also rewards your punctuality with favorable interest rates and increases them if you fail to make payments. It is advised that you stick to loans with full amortization as much as possible, as switching to other forms could be risky.