Amortized Loan - Definition and Example

Paying a Mortgage in Small Increments

An amortized loan is one which has regular periodic payments – usually monthly but can be weekly, bi-weekly, quarterly, etc. which include amounts for both principal and interest (it may also include amounts for things like insurance and taxes but these are extras required by the lender and have nothing to do with the repayment of the loan).

An amortized loan is in contrast to loans on which periodic payments of interest are made and the principal itself re-paid with a single, lump sum payment, commonly referred to as a balloon payment, at the end of the term.

Most consumer loans today are amortized loans, although some lenders offer balloon payment type loans for things like mortgages.

Amortized mortgage loans were championed by the savings and loan industry which began in the nineteenth century as cooperative type organizations in which working people banded together to make small deposits to savings accounts on payday and, when sufficient funds were accumulated, would make mortgage loans to each other with the accumulated savings.

The mortgage loans were amortized loans and the monthly repayment of principal on these loans, along with regular savings deposits by members served to build the pool of loanable funds that allowed ever greater numbers of members to borrow to purchase a home.

The interest portion of the monthly payments was given to the savers as interest on their savings as well as used to cover the organization's overhead. In the popular movie, It's a Wonderful Life, staring Jimmy Stewart and Donna Reed, Stewart's character, George Bailey, heads the local savings and loan and works with its working class members helping them to save money to buy homes.

Interest Only vs Amortized Loans

Prior to the creation of the Savings and Loan industry in the mid-nineteenth century, most loans were of the periodic interest payment and final balloon payment of principal at the end type of loan. The balloon payment type loans usually had short terms of from one to five years.

In the case of real estate, these balloon loans were generally renewed rather than paid off at the end of the term and were more like short term bonds than mortgages as we know them today.

This balloon loan arrangement worked well most of the time but problems arose, especially in the rural western part of the nation when small country banks found themselves strapped for cash and, in order to raise cash, were forced to demand payment rather than renew mortgages when they came due.

Since the banks usually found themselves in this predicament as a result of a downturn in the economy, the borrower's were usually also short of cash and foreclosure followed. In many cases the rural bank sold the mortgages to larger banks in larger cities or in the East and these were the ones who ended up foreclosing on the mortgages during times of economic depression. This is the source of much of the imagery in movies of the greedy and evil banker throwing poor farm and ranch families out of their homes with foreclosure.

The main problem with the balloon type loan is the inability of most people to come up with the money needed to pay off the loan at the end of the term. So long as banks are lending, there is usually no problem, but when money is tight and banks are not lending, foreclosure is the usual result.

The amortized loan is thus a means of allowing the borrower to pay off the debt with small periodic payments and, over the course of fifteen to thirty years, repay the entire loan without ever having to come up with a large sum of money at one time.

How Loan Amortization Works

The way amortization works is by setting the payment at an amount such that it is greater than the interest due on the first scheduled payment.

The interest on the first payment is calculated on the entire loan amount for a period that usually consists of one month. While most of the first payment goes to interest, a tiny portion goes toward reducing the principal.

Because the principal is reduced, the scheduled payment is calculated on the new, slightly lower, balance resulting in a slightly lower amount going to interest. Since the second and succeeding payments are the same size as the first payment, paying a slightly smaller amount for interest leaves a slightly larger amount to reduce the principal.

Initially most of each payment goes to interest with the principal portion growing slowly. But somewhere during the last half of the life of the loan, the portion of the payment going to reducing the principal begins to exceed the portion going to interest. This results in the balance beginning to decrease rapidly and the final payment ending up being a tiny amount to interest and the balance paying off the loan.

A Trick to Pay Loan Off Faster and Save on Interest

Understanding amortization can result in simple strategies to pay off your loan faster as well understanding what to avoid in order to prevent having the term of your loan (and your payments) extended. When an amortized loan payment is calculated, it is figured such that the total number of payments will be sufficient to fully pay the loan within the term.

On longer term loans, like a 30 year mortgage which consists of 360 monthly payments (twelve monthly payments per year times thirty years), any amount you pay in excess of the calculated payment goes to principal and has the effect of reducing the interest portion of each succeeding payment. The extra payment amount results in accelerating the repayment of the loan.

For instance, the amortized payment for a 30 year, $100,000 loan at 10% interest is $877.57. Three hundred and sixty payments of $877.57 will pay off the entire $100,000 loan with interest.

However, if the borrower adds an extra $100 to the first payment, making it $977.57 and have the extra $100 go to principal, he can then make the regular payment of $877.57 for the next 356 months plus a final payment of $679.55 and have the loan paid off two months early for a savings of $1,953.16.

By paying the extra $100 with the first payment, the balance was lowered and this caused the interest due on each succeeding payment to fall at a faster rate than calculated because, in effect the extra hundred dollars you paid first was the last $100 of the loan and was not scheduled to be paid until the 360th payment.

By paying that $100 up front the borrower not only reduced the loan balance by an additional $100 but also directed the interest that was built into each of the following payments for that $100 to be re-directed toward reducing the loan balance.

Conversely, any time a borrower misses a payment and has the interest added to the loan or is late and have the late charge added to the loan, the interest will compound against the borrower and then the loan term and number of payments extended.

Even making a payment late will result in a larger portion of the payment going to interest due to the fact that the balance was higher for a longer period and this will cause the total amount paid over the life of the loan to be some multiple of the extra interest on the late payment.

In closing, there is one simple trick which can save thousands of dollars in interest and reduce the term of a 30 year mortgage loan by a half or more, and that is by making so-called bi-weekly mortgage payments.

Increasing numbers of people are now being paid every other week. In most months this results in two pay checks per month and most of us budget to pay our bills based upon receiving two pay checks per month.

However, since our months do not consist of an even four weeks each, we end up with twenty-six rather than twenty-four two week pay periods per year.

If you have your paycheck deposited directly to your bank account you can arrange with your bank to automatically deduct one half of your monthly mortgage payment and pay it to your lender every pay day. Most people have to set half the mortgage payment aside each pay day anyway or see the bulk of one check go to the mortgage each month.

With bi-weekly mortgage payments the lender gets half the payment two weeks early every month. This alone has the effect of slightly reducing the period for the calculation of interest and results in a slightly smaller amount going to interest each month.

But the real kicker is the extra half payment in each of the two months in which you get three pay checks. On top of the small interest advantage from making each payment a little sooner than calculated, you also get the big wallop from making thirteen rather than twelve full payments per year. We saw above the huge savings from simply increasing the first payment by $100, imagine the effect of making an additional full payment each year. Your mortgage will disappear in no time.

© 2006 Chuck Nugent

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17 comments

Chuck profile image

Chuck 4 years ago from Tucson, Arizona Author

monicamelendez - You are right about paying extra on amortized loans, especially long term ones like mortgages. An extra payment at the beginning of the loan will produce savings well in excess of that payment. The interest savings alone is usually more than the extra payment, and that interest savings each month not only reduces the principle faster (as the extra amount is applied to principle each month but generates further savings from the interest that would have been charged on that extra little principal payment each month now also goes to further reductions in the loan.

Thanks for your comment.


monicamelendez profile image

monicamelendez 4 years ago from Salt Lake City

I have an amortized loan and am completely addicted to making extra payments. It's seriously incredible how much is takes off of the end of the loan to do that. INCREDIBLE. I paid $4000 (my payment is $1030) and it took 8 months off my loan.


lrohner profile image

lrohner 5 years ago from USA

Good job on the hub. But I wanted to make a point about your response stating "many banks not applying the payment until the second half has been received." That is not really accurate. Banks recalculate your loan once per month. Period. You can send them ten different payments during that time if you so desire. It's meaningless unless you have a formal written contract with the lender for bi-weekly payments where they recalculate the mortgage every two weeks.

Any lender can make one additional payment per year, and that has pretty much the same effect as bi-weekly payments.


Valeed profile image

Valeed 5 years ago from Pakistan

Nice hub!

This hub covers a very interesting financial topic :)

I have read about it before but you made it very easy to understand. Thanks for such a nice info hub.


Vital 5 years ago

Very good tips about to pay mortgages automatically or not oft, by decreasing number of payments per month (to 1 payment) or per year (to 3-5 paymets). So using this trick we can save a lot of money, while per period of 30 years we saving our time and moneys. ;)

http://www.greitapaskola.com/


HomeBuyerHelp 6 years ago

Good hub page contents. Much informative!


opismedia profile image

opismedia 6 years ago

NIce article, seems that people could actually same some on the log run, thanks for sharing.


ratelines profile image

ratelines 6 years ago

Checking into early payoffs can be good. Good points!


selina 6 years ago

Good article.But as time goes by,everything is changing.Some point is not so advanced.


OpinionDuck profile image

OpinionDuck 6 years ago

Chuck

Ineresting hub, but the real point should be that the 30 year amortized loan is not today kept full term, but the interest load in the first 20 years is based on the lender going for the full term.

Any loan payoff, or refi results in a big big profit for th lender. I did a hub on that aspect of it.


Chuck profile image

Chuck 7 years ago from Tucson, Arizona Author

MikeNV - Thanks for your input.

In writing this I attempted to offer some different options as people are different and different things work for different people.

However, your emphasis on commitment is right on as without that no trick will work.

Thanks again

Chuck


MikeNV profile image

MikeNV 7 years ago from Henderson, NV

The simplest "trick" is to get a loan with no early payment penalty and to commit to a plan in you own budget that you pay off additional principal monthly. It is in the banks best interest to manipulate payments and fees to their advantage. Writing double the amount of checks will make little difference. The real difference comes from a real commitment to pay off additional principal with each payment.


Loan Modification 7 years ago

nice coverage on

Amortized Loan, little people would talk on that toic at least on hubpages.


Jennifer Bhala Hansen 7 years ago

Thanks for your reply to my comment

All these methods are great for saving some interest but less than 5% of the homebuyers do this apparently.

There is an award winning program that has been created that is the absolute fastest way to pay off not just 'any' mortgage debt, but any type of debt. This is what I use. See hubs and blog to learn more if you are interested.


Chuck profile image

Chuck 7 years ago from Tucson, Arizona Author

Jennifer - thanks for the comment.

You make a very good point about many banks not applying the payment until the second half has been received and this is true of many banks as well as most programs that provide bi-weekly loan payment services and people should be aware of this before signing up for one of these programs. However, these programs can still provide benefits to users. The first one is convenience in that a large portion of wage earners are paid on a bi-weekly basis and find it more convenient to pay half the mortgage payment out of each paycheck rather than setting money asside from one paycheck and adding it to the second paycheck of the month to pay the mortgage.

A second benefit is that, regardless of how the bank applies the payments, paying bi-weekly allows people to painlessly make a 13th payment every year and that will have an acceleration effect on the loan payoff.

Your method of making a full payment to principal at the beginning of each year is definitely superior to one where the bank holds the half payment, without paying interest on the funds being held, until the other half is received, since in your case the balance is reduced at the beginning of the year thereby causing a larger amount of each succeeding payment to go to principal while, in the case where the bank holds the funds until the full payment amount is received results in the 13th payment being just an additional payment and not a full reduction of principal.

Rather than making an extra payment at the beginning of the year and having it applied to principal as you do, on my current mortgage I simply divided the entire payment (principal, interest and taxes) by 12 and added 1/12th of a full month's payment to each monthly payment as an additional payment to principal. While not having quite as powerful effect on the amoritization as your method, it doesn't require me to come up with a full additional payment all at once.

Finally, not all financial institutions hold partial payments until the balance is received before applying them. I had a mortgage a few years ago where the institution applied the funds as they received them. When the first half payment for a month was received they would advance the due date to the next month and show the balance as still due - this still due amount was cleared with the next bi-weekly payment. Of course, after the first 13th payment was made the loan was effectively paid a month ahead so that, over time, the borrower was not only amortizing the loan faster but had a buffer in that if the borrower had an emergency they could skip a payment or two without penalty since the loan was paid ahead (of course, if they did this they lost much of the amortization benefit).

Again, thank you for your comment and suggestion of an additional way to accelerate the payoff of one's mortgage loan.


Jennifer Bhala profile image

Jennifer Bhala 7 years ago from Upstate New York

Bi weekly means the homebuyer is paying 26 half payments versus 12 full payments each year. 26 half = 13 whole monthly payments.

If the homebuyer pays that one extra payment each year towards PRINCIPAL ONLY at the beginning of each year, they would save a lot more than making one extra principal & interest payment each year.

The banks do not apply the first half payment until it has received the second half payment anyway, so why do bi-weekly?

It is not worth the hassle and costs more than one is lead to believe.


EnTrust 9 years ago

Thanks for the article. It seems with a little effort one can save more in the long run.

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