ABC FinanceWhat is loan amortisation

Loan Amortisation

What is loan amortisation

Loan amortisation is the measure of a gradually reducing loan balance over the course of the loan term. Understanding what amortisation is, how it works and how it can impact the amount of interest you pay is key for borrowers.

In this guide, we will explain everything you need to know about this topic in easy-to-understand language. We’ll cover what amortisation is, how it works, and provide examples so that you can get a better understanding of how amortisation affects your loan.

What Is Loan Amortisation?

Loan amortisation is the process of repaying a loan through regular instalments. Loan amortisation is the reason that your loan balance reduces throughout the loan term and results in ever reducing interest.

How does Loan Amortisation work?

Loan amortisation is the process of repaying a loan through regular instalments. With each instalment, a portion of the principal and interest is paid until the loan is fully repaid. The amount that goes towards the principal increases over time while the amount going towards interest decreases. This is due to loan amortisation, as the loan balance reduces, or amortises over the term, the amount of interest due also reduces.

A classic example of this would be a 30-year mortgage. For the first few years, most of your monthly payment will go towards the interest with only a small portion going to the principal. However, as time goes on, an increasingly large portion of your payment will go towards the capital until eventually, almost your entire monthly payment is applied to the principal and the loan is paid off.

What are the types of Loan Amortisation?

Below are the different types of loan amortisation:

  • Full Amortisation (Fixed Rate): This is when the borrower repays both principal and interest every month until the loan is paid off. An example of this kind of loan would be something like a 30-year fixed-rate mortgage.
  • Full Amortisation (Variable Rate): This is when the borrower repays both principal and interest every month, but the interest rate can change over time. An example of this would be an adjustable-rate mortgage (ARM).
  • Full Amortisation (Deferred Rate): This is when the borrower repays only the interest every month for a certain period of time, usually five to ten years. After that, the borrower begins making payments on both the principal and interest until the loan is paid off. An example of this would be an Interest-Only mortgage.
  • Interest only with Balloon Payment: This is when the borrower repays only the interest every month for the life of the loan. At the end of the loan, they are required to pay off the entire remaining principal all at once in one lump sum payment, known as a balloon payment. An example of this would be a balloon mortgage.
  • Negative Amortisation: This is when the borrower repays less than the interest every month, and the unpaid interest is added to the principal. This increases the amount of debt owed and can be very dangerous if not managed carefully. An example of this would be an Option ARM mortgage.

What is a Loan Amortisation Table?

A loan amortisation table is a table that shows how the outstanding balance of a loan changes over time with each regular payment. The table will also show how much of each payment goes towards interest and how much goes towards the principal.

Here is an example of what a loan amortisation table might look like. It is based on a £200,000 loan over 15 years at an interest rate of 6% per annum:

 Beginning Balance  Interest  Principal  Ending Balance 
1 £            200,000.00 £   11,769.24 £   8,483.28 £      191,516.67
2 £            191,516.67 £   11,245.98 £   9,006.54 £      182,510.10
3 £            182,510.10 £   10,690.48 £   9,562.04 £      172,948.02
4 £            172,948.02 £   10,100.73 £ 10,151.79 £      162,796.18
5 £            162,796.18 £      9,474.58 £ 10,777.94 £      152,018.20
6 £            152,018.20 £      8,809.81 £ 11,442.71 £      140,575.45
7 £            140,575.45 £      8,104.05 £ 12,148.47 £      128,426.94
8 £            128,426.94 £      7,354.75 £ 12,897.77 £      115,529.13
9 £            115,529.13 £      6,559.27 £ 13,693.25 £      101,835.82
10 £            101,835.82 £      5,714.67 £ 14,537.85 £         87,297.94
11 £          87,297.94 £      4,818.02 £ 15,434.50 £         71,863.38
12 £          71,863.38 £      3,866.03 £ 16,386.49 £         55,476.86
13 £          55,476.86 £      2,855.36 £ 17,397.16 £         38,079.66
14 £          38,079.66 £      1,782.36 £ 18,470.16 £         19,609.43
15 £          19,609.43 £         643.14 £ 19,609.38 £                          –  

What are the advantages of Loan Amortisation?

The advantages of loan amortisation are:

  • Easy to Budget: It helps the borrower budget as you have certainty that your loan will be repaid at the end of the term, without the need to find a lump sum to repay it.
  • Lower Interest Rates: In some cases, the interest rates for these loans can be lower than other types of loans.
  • Flexible Repayment Periods: Loan amortisation periods can be anywhere from a few years to several decades. This allows the borrower to choose a repayment period that is comfortable for them.
  • Typically Less Interest Over Time: Since the borrower is repaying both principal and interest every month, the loan balance reduces over time. This means that less interest will accumulate over time, which can save the borrower money.

What are the disadvantages of a Loan Amortisation?

The disadvantages of loan amortisation are:

  • Can Pay a Lot Back: The borrower may end up paying higher monthly payments than would be the case with a revolving credit facility or interest only loan.
  • Rigid Repayment Schedule: The borrower is required to make fixed payments every month, leaving little flexibility to pay less when cash flow is tight.
  • Penalty for Early Repayment: In some cases, the borrower may be charged a penalty if they repay the loan early. This is because the lender loses out on the interest that they would have earned if the borrower had kept the loan for the full term.

How do you calculate interest on amortised loans?

Amortised loans are quite easy to work out in terms of finance and how they work since you have a set amount of credit, to begin with and this simply gets lower over time as regular repayments are made.

The formula is as follows:

Loan amortisation formula

Is loan amortisation tax deductible?

No, loan amortisation is not tax-deductible. This is because the interest on the loan is already being paid back with each monthly payment, so there is no need for it to be tax-deductible. This means that the borrower will not be able to deduct any of the interest paid on the loan from their taxes.

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