An amortizing loan has a fixed term during which the borrower makes regular payments until the principal balance has been paid off. Lenders calculate the total amount of principal and interest that is due over the course of the loan term and divide the total into a set number of payments. The payment schedule is known as an amortization schedule.
Borrowers normally make monthly payments on an amortizing loan, and the payments are steady throughout the duration of the loan. Banks calculate interest accrual either annually, monthly or daily. Months and years have uneven numbers of days, so many amortization schedules for long-term loans have payment amounts that fluctuate.
Mortgages are one type of amortizing loan product. Only fixed mortgages have amortization schedules, because adjustable-rate mortgages involve variable rates, and that prevents banks from being able to forecast principal and interest payments over the course of the loan. Home equity loans usually have fixed terms and are another type of amortizing loan, but home equity lines of credit do not amortize because they involve revolving credit lines and do not have fixed interest rates.
Lenders use amortization calculators to pre-qualify loan applicants for fixed loan products. Loan underwriters examine the debt-to-income (DTI) ratios of prospective borrowers by comparing their net income with monthly debt payments. With the use of an amortization calculator, a lender can determine how much a proposed loan would affect the applicants DTI. Many banks restrict DTI to a certain percentage, such as 40 or 50 percent, so if an amortization schedule shows that a new loan would cause the borrower to exceed the DTI maximum, then the loan cannot be written.
Banks must carefully price an amortizing loan, because interest rates change on a regular basis, and lenders cannot raise rates during the term of the loan. If a bank writes a loan with a very low interest rate, it might become unprofitable if interest rates rise, because the interest paid on the loan might not keep pace with inflation. If a bank has to pay increasing taxes, wages and borrowing costs over time, but its income from existing loans does not exceed those rising costs, then the bank could face financial collapse.
Payments received for an amortizing loan are primarily used to cover interest in the early part of the loan term. As time passes, the percentage of the payment going to interest decreases and the principal payments increase until the final payments go entirely to principal. Borrowers can reduce the term of an amortizing loan by making additional principal payments during the term.