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What Is An Amortising Loan and How Does It Work?

The word ‘amortisation’ might not inspire confidence in loan holders, or any word related to debt that contains the Latin root for “death”, for that matter. However, a deeper understanding of loan amortisation can help dispel your financial fears.

Amortising loans are also referred to as instalment loans. Simply stated, they are a type of loan repaid in regular, periodic instalments. Payments are made to both the principal balance on the loan and interest that has accrued on that balance. With regard to payments, interest and principal actually have an inverse relationship over the lifespan of the loan.

Taking a closer look at the origins of the concept, you’ll see that the meaning is actually embedded in the term. The Latin word admortire actually means ‘to kill’. So, the term can be said to mean that the holder of an amortising loan is ‘killing’ their debt over time.

Principle and interest

Interest on an amortising loan is calculated by multiplying the current balance by the interest rate. Loan payments are first applied to the interest owed, then to the principal balance. So, for example, if you are paying back a $10,000 personal finance loan you’ve agreed to pay in 10 months at an interest rate of two per cent, your first payment of $1200 will be apple as follows:

$200 will be applied to interest on the current balance of the loan ($10,000 x .02 = $200)

$1000 will be applied to the principal balance of the loan ($10,000/10 months = $1000)

After this payment, the balance of the loan will be $9000.

The second payment will be $1180.

$180 will be applied to interest on the current balance of the loan ($9,000 x .02 = $180)

$1000 will be applied to the principal balance of the loan ($10,000/10 months = $1000)

The principal balance has now been reduced to $8000.

The third payment will be $1160. And so on.

As you can see, with each payment made, the interest amount decreases because the principal balance upon which it is multiplied has decreased. With each subsequent payment, the amount of money applied to interest is reduced, and the amount applied to the principal is increased. Depending upon the amount of the loan and the interest rate, it may take a while before the amount paid to the principal is more than that paid on interest. Either way, this definitely gives loan holders an incentive to make those payments!

Types of amortising loans

Common types of amortising loans include:

  • auto loans

  • home loans (also known as fixed-rate mortgages)

  • personal finance loans

Loan amortisation schedule

In straight-line amortisation, the amount of interest paid is distributed equally until the debt expires.

Using a loan amortisation calculator to estimate the amount you can afford to pay, how often, and over what time period is a good way to ensure you can afford an amortising loan before committing to one. Compiling this data into a schedule provides a complete picture of the process of paying off an amortized loan by the maturity date.

A loan amortisation schedule consists of rows and columns. Rows represent the payment period. Using the example of the $10,000 personal finance loan described above, in which the debtor has agreed to pay monthly over a ten-month period, the loan amortisation schedule will have ten rows. Columns will include information such as: the payment period, payment amount, principal portion of payment, and interest portion of payment.

Worried about a loan amortisation problem?

It can be scary to commit to an amortising loan. To avoid problems, don’t underestimate the value of a loan amortisation calculator in making sure that your repayment schedule is feasible. Be sure to take into account factors such as your current financial profile, projected earnings, and the possibility of an unexpected economic downturn as well.

Another strategy is similar to making advance payments. Try paying more than the amount owed when you can. This process, called accelerated amortization, can help chip away from the principal, while saving you money in interest.

And if you get in over your head, the assistance of an accountant may be the best choice.

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