An amortizing loan is a simple loan in which payments are paid simultaneously on both the principal of the loan as well as the interest that is owed for that loan. This is what most fixed-interest house loans are made up of as you can typically see your payment schedule and how much of each payment will be principal and how much will be of interest. Whenever making a large purchase that involves a long-term commitment, you may want to work with a financial advisor to help get your finances in order and make sure you’re making the right decision.
What an Amortized Loan Is
The concept behind an amortizing loan is very simple. The goal is for the borrower to eliminate debt, so payments are simultaneously made on both the principal of the loan as well as the interest. The payments are typically set up on an amortization schedule, and, if followed, everything will be paid off at the end of the loan. The majority of mortgages are amortizing loans.
Both the lender and the borrower benefit from an amortizing loan. For the lender, they receive a set and unchanging payment of both principal and interest each month, and for the borrower, if he or she makes on-time payments each month, the risk to their credit or to paying extra charges is greatly limited.
How an Amortized Loan Works
As we said, an amortizing loan is paid off according to an amortization schedule, which is set up before the first payment is made.
Let’s say you want to buy a house and you buy a $200,000 house with $50,000 as a down payment. With an interest rate of 3.75% on a 30-year fixed loan for the rest, your monthly mortgage payments will stay consistently at $695. As you pay off the loan, though, the amount you are paying on principal will increase, while the amount you pay on interest will decrease.
For example, at the outset of year 1, you’ll be paying $227 in principal and $468 in interest per month. At the outset of year 5, however, the amount you’ll be paying in principal will have jumped to $263 and the amount in interest will have dropped to $431.
As we said, an amortizing loan is a fairly simple concept, and it’s a pretty prevalent part of the mortgage world. If you want to play around with some numbers and get a better feel for yourself, check out SmartAsset’s Mortgage Calculator tool.
Amortized Loans vs. Revolving Debt
Revolving debt is where you borrow against a credit line, such as when you use a credit card. You can keep borrowing as long as you have not hit or exceeded your limit as long as you are making required payments. Whatever you owe at the end of the billing period is charged interest that is tacked onto the balance that you owe. There are no set payment amounts or total fixed loan amounts at any time.
This makes it harder to predict what you’ll be paying for the amount of money that you’re borrowing with revolving debt compared to amortized loans. You also could be paying much more in interest if you don’t pay the balance off very quickly because you’ll just continue to accumulate owed interest every month that there is a balance. An amortized loan is a more predictable debt instrument which makes it a better fit for large purchases.
The Bottom Line
An amortized loan comes with a specific payment schedule that breaks down what you’ll pay from the balance that you owe and from the interest accumulated on the account. It’s a predictable debt instrument that can help you make a large purchase, such as a mortgage. It compares favorably to other debt instruments, especially for large purchases, because it is predictable and straightforward to understand.
Tips for Buying a House
- When you make a large purchase, such as a house, it’s important to not only prepare your finances but to also make sure your new commitment fits. You can work with a financial advisor who can help you make a financial plan and ensure that you’re making the right long-term financial decisions. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Looking for the right loan for your new house? Consider all of your options and read through our guide to choosing the right mortgage to help you better understand your decision.
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