What is an Amortization Loan?
Amortization refers to the practice of paying something off with a series of equal payments. Since amortization loans are one of the most common loans on the market, it’s good to know exactly how these loans work. This guide will cover all you need to know about amortization loans, from the fundamentals to the finer details.
How an Amortization Loan Works
With an amortization loan, you’re paying the balance on your loan through equal payments on a set payment schedule. Here’s an example of how this would work:
- You want to purchase a new car for $25,000. After you put down $5,000 upfront, you borrow the rest from a bank, ending up with a $20,000 auto loan that has a 5-percent interest rate.
- Your monthly payment amount is $380.
- You make the same monthly payment of $380 for the next 60 months until the loan is paid off.
That’s an amortization loan in a nutshell. It’s fairly simple and easy to understand because nothing on your end changes. As long as you have the loan, you can expect to pay that $380.
What Types of Loans Use Amortization
Many of the most common types of loans use amortization. These include:
- Auto loans
- Business loans
- Heavy equipment loans
- Personal loans
Keep in mind that this doesn’t mean the types of loans above are always amortized, as there are other options available. Amortization loans just tend to work well for borrowers and lenders because of their consistency. The borrower doesn’t need to worry about their payment amount changing, and the lender doesn’t need to worry about a higher payment amount causing the borrower to miss a payment.
The opposite of an amortization loan would be a loan with a balloon payment. A balloon payment is when the borrower makes low payments throughout the term of the loan, but then has a much higher final payment to cover the remaining balance.
Vehicle title loans and payday loans are examples of loans that follow the balloon payment model instead of the amortization model. Mortgages can have varying payment amounts in the case of an adjustable-rate mortgage (ARM). Lines of credit, including credit cards, don’t have amortized payments because the amount the borrower owes will change as they use their credit and pay it down.
The Structure of an Amortization Loan Payment
Although the payment amount stays the same with an amortization loan, the structure of that payment amount does not. In the early stages of the loan, you pay a higher portion of interest. As the months go by, each payment of yours gradually counts less towards the interest and more towards the loan principal
In that auto loan example we used above with the $380 payment, the payment in the first month may be $290 loan principal and $90 interest. By the time you reach the 60th and final month, your $380 payment would be closer to $378 loan principal and $2 interest.
What this means for you is that if the loan is for an asset, such as a home or car, you’ll build much more equity in that asset towards the end of the loan term.
Amortization loans are as safe a choice as you can get when it comes to loans. Your loan payment is locked in from the moment you sign on the dotted line, making it easy for you to set up your budget and avoid surprises.