What is an Amortizing Loan?

K. Kinsella

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.

People getting a loan.
People getting a loan.

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.

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Discussion Comments

bagley79

I think there have been some significant changes in the debt-to-income ratio in the last few years. At one time, our son was pre-approved for a mortgage loan that was way more than he could really afford. He ended up losing the house because he could not make the payments.

Personally, I don't like my mortgage payment to be more than 30% of my DTI. It might mean I live in a smaller house, but I also don't have so much pressure to make a huge house payment. It seems like there are always other expenses that come up along the way, so this way I have the money to cover them.

A good amortizing loan calculator can help you see the numbers in black and white and help you make an informed decision. When it comes to my mortgage loan, I want to know as much as I can before signing those papers.

golf07

I didn't realize that you couldn't amortize a home equity loan until our banker told me this. I always like to amortize a loan so I can see where my money is going.

Since a home equity line of credit has a revolving interest rate, it does make sense why you can't amortize it. The rate is constantly changing and there would be not way to effectively calculate it.

I don't like to take out loans if I don't have to, but when our teenagers were all driving at the same time, we had a lot of unexpected car expenses where we needed to get a loan.

A home equity line of credit was the easiest way to do this. Once we got back on our feet again, I paid this loan off so the we had all the equity in our home again.

sunshined

When we refinanced our loan to get a lower interest rate, the bank printed off a copy of an amortization schedule for us. Since we were hoping to pay this off sooner than what the terms were set for, using a mortgage payment calculator has really been helpful.

As soon as you make any type of extra payment at all, the original amortization schedule will be outdated. I really like being able to go online and figure out these calculations myself.

Years ago, I made up my own amortizing schedule by hand month by month. This isn't hard to do, it just takes time, and being able to use a calculator for this specific information is so much easier.

SarahSon

The very first time I saw a loan amortization schedule I was amazed at the amount of money that went to interest at the beginning of the loan.

This makes sense since the bank wants to be sure and get their money up front, but it was just a big eye-opener for me.

I had someone once tell me if I could make a little bit extra payment every month, I would be able to pay off the loan much faster. Sometimes this can be hard to do, but when you realize how much money you are paying in interest, it is good motivation to do so.

I used an online mortgage loan calculator which gave me a good idea of the specific breakdown I was paying each month of principal and interest. I could also plug in other variables like interest rate and length of the loan to see if it would be worth getting a loan with a lower interest rate or not.

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