Debt consists of the principal, what you original borrowed, and the interest, which is added over time. Most debt is amortized, which means payments cover both the interest and part of the principal so the total amount owed goes down over time. Unamortized debt, in contrast, has payments of interest only, which means the debt never goes down with the minimum payments.
How Unamortized Debt Works
At its most basic, unamortized debt just means that the mandatory payments are for the interest only. However, this doesn’t mean you get out of the principal. Fixed-term unamortized debt switches to amortized payments after several years, which results in significantly larger payments if you didn’t voluntarily pay down the principal earlier. Increased payments work out for borrowers who increase their income considerably in those intervening years.
When to Use Unamortized Debt
A debt that never goes down seems senseless, but is a useful tool for a small minority of borrowers. This type of loan is used most often by people with irregular incomes, such as those who depend on end of year bonuses or contractors who receive lump-sum payments at unpredictable intervals. They are able to pay the low interest-only mandatory payments regularly and then pay down the principal when they have the extra cash.
Banks consider unamortized debt to be much riskier than amortized debt because there is no guarantee that the borrower will make voluntary principal payments or be able to handle the increased payments later. As a direct result, for two loans identical except for amortization status, the unamortized loan will have a higher interest rate. The risk is considered so great, in fact, that according to the New York Times Freddie Mac stopped offering unamortized mortgages entirely in 2010.
Putting off paying down the principal will increase your total cost for the loan even if an amortized and unamortized loan had the same interest rate. For example, a $200,000 amortized 30-year mortgage would cost $955 a month for a total of $343,739. The same loan unamortized for the first 15 years would start at $667 a month. This would jump to $1,480 at year 15, and the total cost over the lifetime of the loan would be $386,348, if you never paid any principal in the first half.
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