It can be hard to know if you are getting a good deal on your loan. Here is everything you need to know about amortization and loans, so you’ll never pay too much.
What is loan amortization?
Despite the technical name, an amortized loan is a common loan type that you’ll come across in your day-to-day life.
Put simply, amortization is the process of settling a debt by making regular, fixed repayments. These repayments are generally made over a pre-arranged period of time and are made until the loan’s balance hits zero.
There are plenty of loans out there that have an element of amortization. The most common examples are personal loans, such as those from your bank, home loans, and auto loans.
However, not all loans have amortization. Credit cards, revolving credit facilities, and interest-only loans, for example, do not contain an element of amortization. Neither do any loans that offer a balloon payment at the end of their term.
So what’s the main difference between an amortizing and a non-amortizing loan? The answer is surprisingly simple. An amortizing loan is made up of both principal and interest, whereas a non-amortizing loan generally isn’t. Let’s look at what the terms “principal” and “interest” mean in more detail below.
Related: How Much of a Home Loan Can You Afford?
Understanding the difference between principal and interest
As stated above, an amortized loan is made up of two parts. A portion of the loan comprises the principal, which is the actual amount borrowed. Another portion of the loan then comprises interest, which is interest calculated on the principal’s balance.
When you start to pay off an amortized loan, the majority of payments will reduce the interest on the loan. As a result, the principal loan value will remain largely untouched. This is often the case with home loans, for example.
As time goes on, you will repay more of the principal balance and less interest. This will occur until you finally clear the loan balance in its entirety. Note that you will always pay the same amount each month. Only the ratio between how much interest and how much principal you pay off the loan will change.
It goes without saying that it is important to know how much of an amortized loan’s balance comprises interest, and how much relates to the principal. This is because, if you have this knowledge, you know how much interest you have left to pay. The sooner you can then settle any interest amounts, the quicker you can pay off the actual principal of your loan.
How to calculate amortization
The best way to find out about the interest and principal components in an amortized loan is to use an amortization calculator.
There are a few ways that you can calculate the amount of amortization on your loan. For instance, you could choose to calculate it yourself. However, for most people, it is much quicker and easier to use an online amortization calculator to work out just how much interest you will pay. You can also use an online mortgage amortization calculator for any home loans that you have if you prefer a more tailored calculator for that particular loan.
A good example of an online amortization calculator can be found here.
Keeping track of payments
Once you’ve used an amortization calculator, you should know the amount of interest a loan will charge. Once you know this, you can keep track of your findings in an amortization schedule.
An amortization schedule provides an overview of your loan repayments. It does this by outlining your repayments from the beginning of the loan term until the final payment. It also breaks down the proportion of your repayments that relate to interest repayments and the proportion that pays off the loan principal.
You can find a good example of an amortization schedule, along with instructions on how to make your own amortization schedule, here.
Amortization schedules are really useful.
This is because they can be a way of comparing the true cost of a number of different loans.
The aim of any loan is to try and pay as little interest as possible. An amortization schedule should tell you which loans offer the best value for money in terms of the lowest interest cost.
Although there may be loans that offer a lower monthly repayment, these types of amortized loans generally last a longer period of time. This means that, although the loan appears more affordable, you will actually pay much more interest on that loan principal over the course of the loan’s life.
If you can afford higher monthly repayments, this may be a way to save on interest cost. This is because you should reduce the amount of interest charged on your principal. Adopting such an approach could potentially save you thousands in the long-term.
What to do if you already have an amortized loan
The above advice is useful if you are looking at taking out an amortized loan. However, what do you do if you already have an amortized loan, such as a home or auto loan?
Your first point of call would be to look at an amortization schedule for that particular loan. Ideally, your loan provider would have provided this to you when you took out the loan. However, if they didn’t, you could either contact them to request one, or you can create your own amortization schedule. Generally, as long as you at least know the term of the loan and the number of your repayments, you should be able to create your own schedule.
3 Ways to reduce interest payments
Once you have your amortization schedule, you should have an idea of the true cost of your loan. If you want to try and reduce the amount of interest you are paying, there are a few avenues you could consider:
- See whether you can repay your loan early. Doing so should reduce the amount of interest paid over the loan’s life;
- See whether you can overpay during your monthly repayments, as this should also help to reduce any interest balance faster; or
- Try to arrange to make repayments every two weeks, rather than once a month. This should also reduce interest charges.
Before undertaking the above, you should always check with your loan provider that the terms of the loan allow for one or more of the above approaches, as you do not want to breach the terms and conditions of your loan. You should also check and confirm with the loan provider that the amount of interest on the loan will reduce, to ensure that any changes to your payment terms will be beneficial for you. If you are ever in doubt, it is best to consult your financial adviser before taking action.
Our Final Two Cents
Regardless of whether you have already taken out an amortized loan, or you are looking to take out a new home, auto or personal loan, it is important to be aware of the true cost of an amortized loan. By understanding that such loans comprise an interest and principal portion, you can go a long way to ensuring that the loan you take out is the most affordable for you and your family, both in the short and long term.