Loan Amortization Explained

Loan amortization is the distribution of a single lump-sum cash flow into many smaller cash flow installments, which is determined by an amortization schedule.

As far as banking and finance are considered, an amortizing loan is one in which the principal of the loan is paid down over the life of the loan, according to an amortization schedule, typically through equal payments.

Types of Amortization

There are several types of loan amortization which include:

  • straight line (linear)
  • declining balance
  • annuity
  • increasing balance (negative amortization)

Amortization Schedule

An amortization schedule is a table detailing each periodic payment on an amortizing loan (typically a mortgage), which is generated by an amortization calculator.

Amortization schedules run in chronological order. The first payment is assumed to take place one full payment period after the loan was taken out. The last payment completely pays off the remainder of the loan. Often, the last payment will be a slightly different amount than all earlier payments.

Amortization Calculator

A loan amortization calculator is used to determine the periodic payment amount due on a loan, based on the amortization process.

Although the total amount of each payment is the same, the amortization repayment model factors varying amounts of both interest and principal into every installment.

An amortization calculator can also reveal the exact amount that goes towards interest and the exact amount that goes towards principal out of each individual payment.

The amortization schedule is a table delineating these figures across the duration of the loan in chronological order.

Amortization Chart

An amortization chart is created from an amortization table or amortization schedule to show visually how the following changes over time:

  • balance
  • cumulative interest
  • principal

Amortization charts are also very useful for comparing two different loans. You can create a simple amortization chart for loan amortizing in Excel. Just a spread sheet will do.

Repayment Terms

When looking at loan amortization, your repayment terms are very important things to be considered. This will tell you how long you will have to pay back the debt to your lender. Try to keep this as short as possible because the longer the term you choose to pay your loan over, the longer your loan will be collecting interest.

Interest can add up quite quickly so it is important to balance your interest rate with your terms.

Negative Amortization

As far as loan amortization is considered, you should be very careful. Failure to do so can get you into a situation where you are realizing negative amortization and are actually losing money. In most case when people become in negative amortization loans, they do so with the intention of refinancing out of it at a later date.