Fully Amortizing Loan 2021-04-30 08:00:00

Fully Amortizing Loan

A fully amortizing loan is a type of loan which is completely paid off by the end of its term, given the borrower makes complete payments based on the loan’s amortization schedule. Whereas fixed rate loans will have equal payments of interest and principal over its term, debt service on floating rate loans will change as the interest rate changes. Due to the fact that all principal will be paid off, fully amortizing loans will not see a balloon payment at the end of its term, regardless of whether it is fixed or floating.

Usually, at the beginning of a fully amortizing loan, more of the payment goes to interest than principal. Around the middle of the loan’s term, an equal amount of the payment will interest and principal. Going into the back half of the loan, more of the payment goes to the principal. 

Because more of the payment is going to principal during the back half of the loan, its pay down is accelerated. This doesn’t mean the loan will be paid off sooner. It will still be paid off based on the amortization schedule. The accelerated back half pay down is balanced out by the much slower front half pay down. 

Before amortized loans existed, home loans were difficult to pay off because of how they were structured. There were loans with only five-year terms, very large payments, and high interest rates. These loans resulted in higher default rates.

Amortized loans mean smaller payments that are spread out over longer periods of time. This made the loans more manageable for homeowners and resulted in fewer defaults. Even with this structure, banks still get their interest. As mentioned above, the majority of interest is paid in the front half of the loan. If you default on the loan, the bank has made back much of the interest since the interest is front-loaded.

A related concept is negative amortization, which occurs when the payment isn’t enough to decrease the loan. For example, the payment only partially pays down the current month’s interest. This leaves interest to slowly increase every month, along with the overall loan. In summary, a negatively amortized loan increases steadily rather than decreasing.

A straight note loan is one that remains steady after every payment. Similar to a negative amortization loan, it doesn’t decrease, but it also doesn’t increase. These loans usually apply the full payment to interest only.

 


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