When you take out a loan, the chances are good that you will be given a detailed description of your loan repayment terms prior to signing the final contract. Although a variety of repayment options will likely be available, it is almost certain that you will encounter the term amortized or amortization in the process.
When a loan is fully amortized, this implies that the borrower will make payments throughout the lifecycle of borrowing that, once completed, will have completely paid back all principal and interest. Understanding how a fully amortized loan functions with respect to other loan payment mechanisms available today is critical.
With a fully amortized loan, each regular payment made on the balance of the loan will target both principal and interest. With that in mind, the final payment on a fully amortized repayment plan should reduce the borrower's total balance to zero.
Basics of Loan Repayment
When an individual chooses to purchase a home, the chances are good that they will be using a mortgage loan to help them finance their purchase. Mortgage loans are composed of the principal balance requested by the borrower as well as an attached rate of interest. This interest rate can fluctuate significantly based on a variety of factors, including the borrower's credit score as well as the size of their down payment.
Once these terms of the loan are established, the mortgage lender will typically offer one of several repayment methods. It is here where the discussion of interest accrual and amortization begins.
Mortgages and Interest Rates
As a general rule, mortgages will either feature a fixed or adjustable interest rate. The differences between the two are significant. With a fixed rate of interest, the borrower will be provided with a designated annual interest that remains constant throughout the full duration of their loan. Keep in mind that this does not influence any details regarding how the interest compounds, but rather exclusively the fact that the interest rate will not change throughout the duration of the loan.
Unlike a fixed-rate mortgage, an adjustable rate will change throughout the lifespan of the loan at regularly dictated points of time. These changes will not be unexpected; in fact, borrowers will be provided with a rate schedule at the initiation of their loan which fully describes any and all fluctuations to the interest rate throughout the lifecycle of their borrowing.
Fully Amortized Borrowing
Once the details of the loan have been finalized with respect to the actual of interest, the borrower will need to understand exactly how their payments contribute to the payoff of their debt. With a fully amortized loan, borrowers will be paying down both their principal and interest through the payoff schedule. In the early payments of the loan, borrowers will mostly be paying down their interest balance.
As time progresses, these payments will gradually shift in composition and be composed primarily of funds heading toward the repayment of principal. Once the payment schedule has been completed, the borrower should be completely free of any remaining loan balance. This differs from a partially amortized loan, in which only specific elements of the debt (i.e. interest) may be addressed by payments.
Amortization and Interest Rates
In the event that a loan features a fixed interest rate and is fully amortized, the regular payments on the balance will most likely be identical in size. However, if a loan features an adjustable interest rate, it is fully possible that the size of these payments will change over time given the fact that the rate of interest accrual is shifting.
Details such as these are critical for borrowers to fully ascertain in order to ensure that they completely understand what is expected of them with respect to loan repayment. Individuals who have additional questions about the type of amortization attached to their loan should consult with their loan servicer as soon as possible.
Ryan Cockerham is a nationally recognized author specializing in all things innovation, business and creativity. His work has served the business, nonprofit and political community. Ryan's work has been featured at Zacks Investment Research, SFGate Home Guides, Bloomberg, HuffPost and more.