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Tata Capital > Blog > Loan for Home > What Is An Amortized Loan And How Does It Work?

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What Is An Amortized Loan And How Does It Work?

What Is An Amortized Loan And How Does It Work?

Loan amortisation is a financing instrument wherein the borrower pays off a fixed amount of payment throughout the loan period. While the first part of the loan payment goes towards repayment of interest, the remaining amount goes towards repayment of the principal.

Though the loan amortisation determines the minimum loan payment amount each month, it does not restrict the borrower from making additional payments. Therefore, if there is an additional payment made by the borrower, it goes towards the payment of the principal amount of the loan. Loan amortisation allows the borrower to save on the total interest amount to be paid during the loan tenure.

Common amortised cost loans

Some common amortised cost loans include:

  • Auto loan
  • Student loan
  • Home equity loan
  • Personal loan
  • Fixed-rate mortgage

What is the difference between amortised and unamortised loans?

In an amortised loan, the borrower’s monthly payment includes both elements – the principal and the interest. However, in the case of unamortised loans, the borrower just repays the interest during the entire loan period and ends with a final balloon payment for the principal loan amount.

This is the reason why monthly amortisation is a prudent step for borrowers; it lowers the payout as compared to unamortised loans. It is also not always easy for a borrower to make a balloon payment to close the loan. Therefore, an amortised cost loan makes more sense as it allows borrowers to pay extra during the loan period that goes directly towards the repayment of the principal amount.

Some examples of unamortised loans include:

  • Credit cards
  • Mortgages
  • Home equity lines of credits

How does loan amortisation work?

An amortised loan is broken up into an equal repayment schedule over the entire loan period. The repayment amortisation is calculated in accordance with the loan amount, tenure and interest rate. Loan amortisation allows the borrower to see how much they will be paying off every month as interest and principal amount.

A detailed loan amortisation schedule can also help borrowers to:

  • Calculate how much interest they can save over the loan period by making additional payments at regular intervals.
  • Calculate the total amount of interest that they would be paying each year and its tax implications.
  • Find out how much loan they would be able to afford and what suits them the best.

Difference between amortised loans, balloon loans and revolving debt (credit cards)

While all the three – amortised loans, balloon loans and revolving debt - look similar, they all have their distinct characteristics. A borrower should be aware of them before signing up for any one of them.

Amortised loans

Amortised loans are predominantly paid over a longer period of time with equal monthly payments. Moreover, if the borrower chooses to make extra payments, these directly reduce the principal loan amount.

Balloon loans

Balloon loans relatively have a shorter term. In this kind of financing instrument, the principal amount of the loan makes a smaller portion of the monthly repayments. Instead, the final repayment is generally huge and also called the balloon payment.

Revolving debt (Credit Cards)

Among the various revolving debt instruments, credit cards are the most popular ones. In the revolving debt option, a borrower takes a loan against an established credit limit. A borrower can continue borrowing money until the credit limit is reached. Credit cards, like amortised loans, do not have fixed loan amounts.

Steps for Calculating Amortisation

  • Collect all the information you need to calculate the loan amortisation - You will need the principal amount, interest rate and term of the loan to calculate the loan amortisation.
  • Prepare a spreadsheet - You need to create an amortised loan table.
  • Calculate the monthly repayments - You can calculate the monthly repayments of the amortised loan based on the principal amount, interest rate and term of the loan.
  • Analyse the trends and impact of loan amortisation - Once the amortisation table is prepared, you can see that over the period of the loan tenure, the interest charged declines gradually, and the principal portion increases with every payout. Towards the end of the loan term, your balance should be much smaller.

What is an amortised loan table?

An amortised loan table lists all the scheduled payments towards a loan as per the loan amortisation calculator. Typically, an amortisation table consists of:

Loan details – All details related to the loan, such as the loan amount, term and interest rates, are mentioned in this column in the amortised loan table.

Payment frequency – In this column of the amortised loan table, the frequency of the payment during the loan period is mentioned. Typically, the payment frequency in amortised loans is monthly.

Total payment – In this column, the borrower’s total monthly payment is calculated and presented.

Extra payment – If the borrower makes an extra payment, then the amortisation calculator applies the extra amount paid to the principal and calculates the interest payments further based on the updated loan balance.

Principal amount repayment – This column indicates how much of the monthly payment is towards the loan principal. The principal amount repayment increases every month over the tenure of the loan.

Interest cost – This column tracks down the payment that goes towards loan interest. The amount of interest repaid reduces every month over the tenure of the loan.

Outstanding balance – This column indicates the outstanding balance of the loan.

Key Takeaways

Since amortised loans focus more on a balanced repayment of both interest and principal amounts, borrowers are not left with large principal amounts outstanding at the end of the loan period. Unlike other loan instruments, such as balloon loans or revolving debts, amortised loans are simpler and more convenient for loan needs related to studies, car purchases, or even personal reasons.

Tata Capital has been at the forefront of offering home loan, business loans, education loans and vehicle loans at attractive interest rates. From longer loan tenures to extra payments towards the principal amount to focusing on both principal and interest amounts, amortised loans enable and empower borrowers to take steps towards lower debt and better control of their finances.

To know more about loan amortisation, visit our website.

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