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In multifamily lending, you'll often come across the mention of "amortizing loans." Amortization is the process of spreading out a loan into a series of fixed payments over time. Amortization is commonly used in most loan scenarios where the borrower makes periodic installments, such as with a mortgage or a car loan. With an amortizing loan, the borrower repays the loan's principal balance — the original amount they borrowed — plus the interest owed on the loan over time up to the maturity date, leaving no balloon payment.
Amortization is different from simple interest or interest-only loan structures, where the borrower would only repay the interest that accrues on the loan over time, then must cover the remaining principal in one large balloon sum. In most amortization structures, the borrower pays off a little bit of both the principal and the interest each month, gradually chipping away at the loan's balance. The amount of principal and interest included in each payment is determined by the loan's term length and interest rate.
How Does Amortization Work?
With an amortized loan, payments are spread out in equal sums to be paid over the length of the loan term. Each monthly payment is composed of two parts:
Principal: The portion of the payment that goes toward the original amount borrowed
Interest: The portion of the payment that goes toward the cost of borrowing the money
The amount of principal and interest in each payment will be different as the loan matures because the amount of interest to be paid decreases as the principal gets paid down.
To better illustrate how amortization works, here’s a simple example:
A borrower takes out a $100,000 loan with a 4% interest rate. The fixed monthly payment is $1,000. The first payment is broken down to $400 towards interest and $600 towards the principal. The second payment then becomes $398 towards the interest and $602 towards the principal. This process continues — with the amount of interest paid each month decreasing and the amount paid towards the principal increasing — until the loan is paid off, all while keeping the same monthly installment of $1,000.
Image By Towfiqu Barbhuiya From Unsplash.
The interest portion of the payment is higher at the beginning of the loan because the principal has not been paid down by any amount. As payments are made and the principal balance decreases, the interest portion of the payment will decrease as well. Likewise, the amount of principal in each payment will increase as the loan progresses because the debt is slowly being paid off.
To calculate the interest and principal in a multifamily mortgage payment, you can use our mortgage calculator with the attached amortization schedule.
Advantages of Amortization
Amortization has a number of advantages, both for borrowers and lenders alike.
For borrowers, amortization makes it much easier to budget for loan payments. With a fixed payment each month, borrowers know exactly how much they need to set aside to make a payment. This can make managing finances a breeze and keep borrowers current on their loans.
Amortization can also save borrowers money in the long run. With each payment, both the principal and the interest are paid down. This means that the interest portion of your payment will decrease over time, leaving more of your payment to go toward the principal. This actually can save a borrower a significant amount of money over the life of the loan.
For lenders, amortization provides a steady stream of income. With each payment, the borrower will be paying down both the principal and the interest. Amortization allows the lender to receive interest payments throughout the life of the loan.
Amortization can also help lenders manage their risk. With a fixed payment due each month, lenders can be more confident that they will receive their payments on time. This predictability can help lenders plan for their own expenses and manage their own finances.
Disadvantages of Amortization
Even with the range of benefits regarding amortization, it does have some disadvantages for borrowers and for lenders.
For borrowers, the biggest disadvantage is that amortization can make it difficult to pay off a loan early. Amortized loans are carefully calculated to balance the amounts paid towards the loan’s interest and principal over a long term — meaning most amortized loans carry long loan terms. Additionally, in order to make extra payments on the principal of the loan in order to pay it off sooner, a borrower would need to calculate the amount of the payment that will go toward the principal. Without prior knowledge of how each payment is broken down, this can be a complex process.
For lenders, the amortization can result in a loss of income if the borrower prepays the loan. If the borrower makes a large payment on the principal of the loan, the lender will miss out on the interest that would have been earned on that payment.
Amortization can also make it difficult to sell a loan. If a lender needs to sell a loan before it is fully amortized, they may have to sell it at a discount. This is because the buyer will be assuming the remaining interest payments on the loan.