Amortization Methods

Posted by Mike Smith :: September 27, 2007 @ 6:48 am

Most people who have loans are familiar with the term amortization. In its simplest form, it simply means the reduction of the loan balance through regularly scheduled payments. For a given loan balance, interest rate, and term, the full amortization amount is the principal payment that will reduce your loan to zero over the normal term of the loan. Once you know your full amortization amount, there are four typical categories that you could fall into, depending on your loan.

Full Amortization
Paying the full amortization amount will result in the outstanding balance of a loan being reduced to zero at the end of the loan term. This is the most typical type of loan available, including the person-to-person loans available through Lending Club.

Partial Amortization
By paying a portion of your amortization amount, you will be reducing your outstanding principal on the loan each month. Paying a partial amount will result in an outstanding balance at the end of the loan term.

Interest Only
As the name suggests, paying interest only would not include any amortization payments. At the end of the loan term, the principal would be the same as at the start of the term.

Negative Amortization
Negative amortization loans require even lower monthly payments than interest only loans. As such, monthly payments actually increase the outstanding principal on the loan. The shortfall of payments to the interest amount gets added to the loan amount each month.

To summarize the four categories, consider the example of borrowing $250,000 with a 30-year loan: With full amortization payments, your loan would be paid off at the end of 30 years. With partial amortization, you would owe some amount less than $250,000 at the end of 30 years. With Interest Only, You would still owe $250,000 at the end of 30 years. With negative amortization, you would owe more (possibly much more) than $250,000 at the end of 30 years.

While the discussions over the other types of loans are generally held with regard to mortgages, all loans can typically be categorized in this way. P2P loans from Lending Club are fully amortized. Adjustable rate loans complicate things somewhat, but these same categories generally still apply.

Many of the loans that have been making the news lately fall into the categories other than full amortization. While partial payment, interest only, and negative amortization loans typically have lower monthly payments, I believe that these loans should be avoided. Full amortization loans set a more realistic bound on the type of purchases you can truly afford.

My opinion is that there is only one time when you should stray from the full amortization category: prepaying your loan. Paying more than the full amortization amount, when permitted by your loan issuer, will shorten the term of your loan. Straying into the other loan types is risky business and an action that I would certainly try to avoid.