With few exceptions, you have to make a greater payback on money you borrow than the actual principal amount you receive – with the interest payments you make. This additional amount of interest may be worked into the loan using different calculations, depending on your lender and the type of loan you have. The straight-line interest formula is a different way to structure a loan than the traditional mortgage-style amortization.
Amortizing a Loan
Amortizing a loan is the process by which the total amount of the loan – your debt – becomes reduced over time through the payments you make. Typically, a loan has a fixed schedule of repayments that you make in regular installments. At the loan’s maturity date, when you’ve made all your installment payments, your debt is paid in full. But it’s the amount of principal compared to the amount of interest you pay with each installment that determines whether you’re using a straight-line amortization method or a traditional mortgage-style amortization method.
Mortgage-Style Amortization Method
A typical mortgage is divided into a fixed number of equal payments over the life of the loan. But even though you make equal payments each month, the portion of each payment that is applied toward principal and the portion that is applied toward interest are not equal. In the early repayment years after you start paying on a mortgage, the portion of each payment that’s earmarked for interest is much greater than the portion that’s earmarked for principal. As the mortgage progresses, the roles switch and the portion allocated to principal becomes larger.
To illustrate, look at the example of a $200,000, 30-year fixed-rate mortgage at an interest rate of 5 percent. Your payments are all the same – $1,073.64. But your first payment of $1,073.64 represents only $240.31 toward principal and a whopping $833.33 toward interest. And it’s not until the 17th year of your mortgage that the amount allocated toward principal begins to be greater than the amount allocated toward interest, when the same monthly payment of $1,073.64 represents $538.38 toward principal and $535.26 toward interest.
Straight-Line Amortization Method
Unlike the mortgage-style amortization method, in which monthly payments remain the same, a payment schedule that uses the straight-line amortization method yields varying monthly payments. With principal amounts remaining the same in a straight-line interest formula, it’s the portion that’s allocated to interest that changes with each payment.
This type of amortization is also called constant amortization, because the amount of principal in each payment is the same. Each installment payment is not the same, differentiating it from the consistent installment payments in a mortgage-style amortization schedule, but each one varies, according to the amount that’s allocated to interest.
Using the same numbers above (in the mortgage-style amortization example of a $200,000, 30-year fixed-rate mortgage at an interest rate of 5 percent), each installment payment toward principal using the straight-line amortization method is $555.56 ($200,000 divided by 360 payments equals $555.56). But your interest payment varies each month, applied toward the unpaid balance at the rate of 5 percent.
With your first payment, the interest portion of your payment is $833.33 (for a total monthly payment of $1,388.88), and it’s not until payment 121 (in your 11th year of making payments) that your interest payment of $555.55 is on nearly equal footing with your $555.56 principal payment (total monthly payment at this point is $1,111.11, down from your first payment of $1,388.88). From this point until the loan matures, the portion of your installment payments allocated to interest continues to decrease, which also continues to reduce your total monthly payment.
A financial term that sounds similar to “straight-line” amortization is a “straight-term” loan, but these two terms describe different financial products. The straight loan definition is a type of loan for which a borrower repays only the accrued interest over the life of the loan. At the loan’s maturity date (or another designated future date), the borrower repays the entire principal amount, typically with a balloon payment. Because the payments only cover the interest portion of the loan, the loan balance stays the same.
Another difference between a straight loan and the straight-line amortization method is that straight loans typically have shorter maturities, such as two to 10 years. These loans are also called term loans, interest-only loans or bullet loans.
Straight-Line Amortization Advantage
The amount of interest you pay over the life of a mortgage is less with a straight-line amortization schedule than with a mortgage-style amortization schedule. Using the above example of a 30-year fixed-rate $200,000 mortgage at an interest rate of 5 percent, you’d pay $186,513.24 in interest alone by using a mortgage-style amortization schedule. But if you use a straight-line amortization schedule, you’d pay $150,415.50 in interest payments – a savings from the mortgage-style method of $36,097.74.
Straight-Line Amortization Disadvantages
Because your mortgage may be the largest monthly payment you have, a payment that fluctuates each month may be a little more challenging to work into your budget. And because the straight-line amortization method yields the highest payments at the beginning of a mortgage, you’ll be strapped with these high payments from the get-go. It takes a little time for the payments to become reduced to the point you actually see any significant relief, so you’ll be even more strapped if your income level drops before then.
Mortgage-Style Amortization Advantages
Most homeowners are familiar with the traditional mortgage-style amortization. One advantage of using this method is that it gives you a consistent payment schedule in which you make the same payment each month. Although the principal and interest portions contained in each payment vary from month to month, your overall payment stays the same. This is useful for budgeting.
In addition to its predictability, a mortgage-style amortization schedule also offers greater affordability over time. As your income level generally increases over time, your mortgage does not also proportionately increase, it stays the same. Because you qualified for a certain mortgage amount, and therefore its associated installment payments, you’ll likely be able to afford your payments even more over time as your income increases.
Mortgage-Style Amortization Disadvantages
You’ll pay more interest over the life of your loan by using the mortgage-style amortization method instead of the straight-line method – $36,097.74 more, using the example above. This is a significant amount of money to allocate toward interest payments, above what you'd pay by using the straight-line amortization method. And because you’re paying a much higher allocation of your installment payments toward interest at the beginning of a mortgage-style amortization schedule, it will take you much longer to pay down your principal balance when compared to the straight-line method.
- The Motley Fool: How to Find Interest with the Straight-Line Method
- My Accounting Course: What is Straight-Line Amortization?
- Financer.com: Straight-Line Amortization Vs. Mortgage-Style Amortization
- Financial-Calculators.com: Amortization Schedule
- Investment & Finance: Straight-Term Loan
- Investor Words: Straight Loan