How An Amortized Loan Works

how an amortized loan works

Loans are good or bad depending on where you’re coming. We have all gone for loans in our lives one way or the other and might have had an amortized loan without really knowing. As a result, I will be defining what an amortized loan is and how it works.

According to the credit bureau, about 22% of U.S adults have a personal loan which goes to show how much of our population are into taking of loans. Almost all loans comes with an interest and some form of payment plan. So that is where loan amortization comes in.

WHAT IS AN AMORTIZED LOAN?

An amortized loan is simply any loan that has clear schedule and periodic payments applicable to both the loan’s interest due and principal amount. Therefore, if you have ever gone for a loan that had a scheduled and periodic payment plan like it is defined above, the that loan is qualified to called ‘an amortized loan’.

The commonest types of amortized loans are personal loans, home loans and auto loans. With amortized loan, the borrower first pays the necessary interest for the loan term and then the remaining payment is targeted at reducing the principal.

Having explained extensively what an amortized loan is, let us then go into the subject matter which is to understand how an amortized loan works.

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HOW AN AMORTIZED LOAN WORKS

Understanding how an amortized loan works is simple but can be a little complicated at the same time. This is because it involves some basic math’s which some borrowers don’t’ want to have anything to do with.

To find interest accrued for a period on an amortized loan, the current balance of your loan is multiplied by the interest rate of your loan. As you continue to make payments on payment due dates, the interest amount owed decreases.

Bear in mind that payments which are more than the interest amount reduces the principal amount which then means that the balance on which the interest is calculated also reduces due to the negative correlation between principal and interest.

FORMULA

You can use this formula if you want to know how much of your monthly payment goes into the settlement of your principal although the bank or lender normally does that for you.

Principal Payment = TMP- (OLB*Interest Rate/ 12 Months) where OLB stands for Outstanding loan balance and TMP stands for Total Monthly Payment

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You can also calculate the total monthly payment using this formula;

Total Payment= Loan Amount [( where I = Monthly interest rate, n is number of payments

Example

If you went for an auto loan of $50,000 which is to be paid at an interest rate of 5% for 5 years, this is how payments for the first 5 months is going to be.

Monthly Payment = $50,000

Monthly Payment = $943.56

Out of that amount, $208.33 goes to interest and the remaining $735.23 goes to the principal. As explained earlier, although your total monthly payments remains the same each month, the amount that goes into interest decreases whiles the amount that goes into principal increases.

In this case, your next payment will still be $943.56. However, $738 goes to principal and $205 to principal. The principal amount keeps increasing whiles the interest amount reduces till you finish settling your loan.

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WHAT IS AN AMORTIZATION SCHEDULE

An amortization schedule is the table that details each of your periodic payment on either a home loan, auto loan or personal loan which is normally generated by an amortization calculator. The table/ schedule helps you to identify which part of your payment goes to interest and which portion goes to principal.

How An Amortized Loan Works

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