However, not all loans have a fully amortizing payment structure. It’s crucial to understand what that is and how your finances could be impacted if your loan payments are not fully amortized.
Definition and Example of a Fully Amortizing Payment
Anytime you take out a loan, you’ll want to know if your repayment schedule is based on a fully amortizing payment plan. The term “amortization” means making equally scheduled payments over a set period of time so that each payment decreases the overall balance of the loan.
Alternate name: Self-amortizing payment
When you have a fully amortizing payment arrangement, it means that every scheduled payment you make works to reduce the balance of both the principal (the amount borrowed) and the interest (borrowing fee) during the life of the loan. In the case of a home loan, this means that once the final payment is made, the loan will be fully amortized and the remaining balance owed will be $0. You will have fully paid off your home loan—both the principal and interest. Determining what percentage of a fully amortizing payment goes toward the principal and what percentage goes toward the interest is based on your loan’s amortization schedule. Borrowers can use this schedule as a visual guide to monitoring the pay-off progress of their loan. There are many types of loans that utilize a fully amortizing payment plan. Some of the most common examples include auto loans, home loans, and personal loans.
How Do Fully Amortizing Payments Work?
Fully amortizing payments work by spreading out a loan into a series of equal monthly payments over a set period of time. Each payment applies a portion to the principal and a portion to the interest. During the early stages of the repayment schedule, the largest percentage of the payment is used to cover the interest. However, as the loan continues to amortize over its lifecycle, the amount of money going toward the principal increases. The good thing about a fully amortizing payment structure is that each monthly payment decreases the balance owed so that the loan is completely paid in full by the end of the repayment schedule. Here’s an example of how a fully amortizing payment schedule might look. The formula to compute monthly payments is: Where:
M is the total monthly mortgage payment.P is the principal amount on the loanr is the monthly interest rate (the annual rate as a decimal divided by 12)n is the number of payments over the loan’s lifetime. If you have a 30-year mortgage, then you have 30x12 = 360 payments
Let’s say you borrow $200,000 for a 30-year, fixed-rate mortgage with an interest rate of 3.5%. Your monthly payments would be $898.13. As you can see by the amortization schedule in the table below, the bulk of each monthly payment is being used to pay the interest at the beginning of the loan. Toward the end of the loan, however, the majority of each payment primarily covers the principal amount, with only a small portion going to interest. As long as you stick to the payment schedule, your loan will be paid in full at the end of the contract since this schedule uses fully amortizing payments.
Payment Schedule
Here’s a look at some payment breakouts for the loan example above. You can use an amortization calculator to create your own custom schedule. With a fully amortizing payment plan, each monthly payment applies some portion of the money toward the principal and the interest. Thus, in the early stages of the loan, a larger percentage of each payment is directed toward the interest. However, the roles reverse near the end of the loan, and the principal receives the larger portion. As a result, if you make every payment according to the schedule, the loan will be entirely paid in full once the final payment is made. With a partially amortizing payment, only a portion of the loan is amortized. This means that only a part of the principal will be paid by the end of the contract, leaving you with an outstanding balance due. At that point, to pay off the loan, you will either have to make a lump-sum payment (referred to as a balloon payment), refinance, or get an entirely new loan. Payments can also be non-amortizing. With this type of loan, no principal is paid during the repayment schedule. The borrower essentially only pays the interest on the loan until it matures. Once that happens, the entire principal balance will become due as a lump-sum payment. These are also known as interest-only or balloon-payment loans.
