An amortized loan is a loan where payments are the same amount each month. Each payment pays some of the interest on the loan and some of the principal, or amount borrowed. This type of loan can be total, meaning the payments will stay the same until the set period when the loan is paid off. Alternately partially amortized loans mean that at the end of the set payment period, a large additional payment, called a balloon payment is then due.
Generally an auto loan is likely to be an amortized loan. Especially during the early months of the loan, most of the payment will likely go toward interest. Very little of the early payments will actually pay off the principal, due to the fact that the loan charges all interest upfront. So with any loan of this type, gradually payment to principal increases and interest payment drops, even though the payment amount is the same.
The disadvantage of this type of loan in its first few years is that the percentage of property one actually owns can be very small. In an amortized loan for a vehicle, there is usually a point where the resale value of the car is much lower than the actual amount one would owe on the car if paid off immediately.
This upside down effect occurs because one has spent so little on actual principal amounts and so much on interest. There is usually a pay-off amount that is less than the total amount due on the loan. This may not correspond to the actual value of the car.
If one looks at a home amortized loan, one would see the same effect if house values dropped. For example, in a 15 year 100,000 US dollar (USD) amortized loan at 7% interest, the payment is close to 900 USD per month. Principal paid during the first year ranges from about 300-400 USD, per monthly payment. A larger amount of the payment, about 500-600 USD, pays the interest on the loan.
At the end of the first year of this amortized loan, one might have 3600-4200 USD of principal paid. If house values drop 10,000 USD in that year and one must resell the house, one would do so at a loss, affecting the amount of any down payment one might receive back. Even two or three years into payments, declining real estate values could mean that selling the home could result in a total loss of one’s initial down payment.
One can generally gain more ownership of a property by paying additional amounts to the principal of the loan. Usually one must first find out if the lending agency will allow extra payments to the principal. Further, one should make sure that payments to the principal are clearly marked and are credited as such by the bank or loan company. Sometimes making an additional payment on an amortized loan is viewed as making an early start on one’s next scheduled payment. Be certain to check that the bank is actually crediting these payments “to the principal.”
