Amortised loan: Meaning, how it works, types, example

Loan amortisation refers to a model of loan repayment. This model is chosen by borrowers who are looking for a long repayment period. Let us have a look at what is an amortised loan and the process of loan amortisation.

What is an amortised loan?

An amortised loan is a type of loan where each loan repayment goes towards both the principal sum borrowed and interest rate charged for it. Simply put, under amortisation a part of your loan repayment amount goes towards the interest and the rest goes towards the principal.

How does loan amortisation work?

When a financial institution decides to sanction an amortised loan, they make an amortisation schedule. Also called the amortisation table, this schedule details the EMI to be paid and how much of the EMI goes towards the interest and the principal sum borrowed. A loan amortisation calculator is used to calculate the figures given in the amortisation table.

An amortisation schedule indicates the following details:

• Payment frequency: This is the first column in the amortisation table which lists how frequently you will be making, monthly, quarterly, etc.
• Total payment due: This column indicates the borrower’s total payment due for each installment.
• Principal repayment: This column of the table shows how much principal amount is being paid from the loan repayment amount.
• Interest charged: The interest column highlights how much of each installment goes towards the total interest.
• Outstanding balance: This column indicates the loan balance owed after each repayment. This amount is derived by deducting the loan repayment amount from the current balance.
• Extra payment: Sometimes borrowers pay an extra amount to finish the debt faster. This extra amount usually goes towards the principal sum borrowed. The future interest payments will be recalculated based on the updated balance.

Let us understand this with an example. Imagine you have borrowed a small business loan of ₹10,00,000. The interest rate is 15% and repayment tenure is 60 months. The EMI for the loan is ₹23,789 9 (you can find the EMI for a loan using a business loan EMI calculator). This is how your amortisation schedule will look like for the first six months:

A complete amortisation table like the one above will be sent to you once you get an amortised loan sanctioned. This can help you know all the details of the loan and if needed help you make a foreclosure plan.

Types of amortised loans

Usually, consumer loans are commonly amortised to make it easier for the consumers to pay back the loan. Here are a few types of amortised loans:

• Personal loans

Personal loans are taken by individual borrowers to finance personal expenses like hospital bills or fund expensive purchases. These loans are given to individuals with a minimum credit score as specified by the lender.

• Auto loans

Auto loans are applied for the purchase of an automobile. These loans are usually hypothecated which means that the car or truck you buy with the loan will serve as the collateral. Here each EMI for the loan is split between interest and principal borrowed.

Also read: Commercial vehicle loan: Interest rates, eligibility, online application

• Home loans

Home loans are fixed-rate mortgages that help borrowers buy homes. These loans usually feature high loan amounts, and therefore have a longer maturity period than auto loans. Homeowners also choose to sell their homes to pay off the loans or rent out the property to pay the mortgage.

Pros and cons of amortisation

Given below are the advantages of loan amortisation:

• Amotisation of loan gives a clear and fixed schedule of monthly payments to the borrower
• Since the payment due for each month is fixed these loans are easier to track. Irregular payments can cause a lot of confusion for the borrower.
• Amortisation has become a standard in India for most loans and this has led to a more straightforward loan repayment

Have look at the cons of loan amortisation:

• Monthly payments tend to be huge amounts as they have both interest and principal component.
• Manu borrowers are not aware of the true cost of the loan as they focus on the monthly fixed payments for their budget. One must calculate the total interest to be paid to determine the total cost of the loan.

Amortised loan vs non-amortised loan

Non amortised loans are loans for which payment of the principal amount is made in a lump sum. These loans are unsecured loans with lower installment payments but have higher interest rates. Non-amortising loans are usually used in land contracts and real estate development financing.

Also read: Syndicated loan: Check process, interest rates, eligibility and more

Negative amortisation

With loan amortisation your total loan amount due goes down with each payment. However, with negative amortisation, your loan amount goes up even if you are paying your EMIs. This is because you are not paying enough to cover the interest.

Therefore, the unpaid interest amount of the particular month gets added to the total amount due for the loan. This means that after a period of time, you will end up making huge monthly payments top finish off your loan.

Why is amortisation important?

Loan amortisation is plays an important role when it comes to business budget decisions. Business owners can easily understand and forecast their costs over time because the payments are fixed instead of irregular.

Amortisation schedules contributes to clarity in terms loan repayment amount especially how is your payment split between interest and principal. This can be useful for claiming tax deductions on GST forms. The schedule can also shine a light on company’s future debt balance.

Amortised loan vs non-amortised loan

Non amortised loans are loans for which payment of the principal amount is made in a lump sum. These loans are unsecured loans with lower installment payments but have higher interest rates. Non-amortising loans are usually used in land contracts and real estate development financing.

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