Fully Amortized Loan: A Definition
Kevin Graham4-minute read
December 14, 2020
Whether you’re looking at applying for a mortgage or any other type of financing, it’s a good idea to make sure you understand the model under which these loans are paid off. In this way, you can fully educate yourself before taking on the repayment obligation.
Most loans, including mortgage payments, have both principal and interest paid during the loan term. What differs from one loan to the next is the ratio between the two, which determines the rate at which principal and interest are paid off. In this article, we’ll be discussing fully amortizing loans and contrasting these with other payment structures.
What Is A Fully Amortized Loan?
A fully amortized payment is one where if you make every payment according to the original schedule on your term loan, your loan will be fully paid off by the end of the term.
The term amortization is peak lending jargon that deserves a definition of its own. Amortization simply refers to the amount of principal and interest paid each month over the course of your loan term. Near the beginning of a loan, the vast majority of your payment goes toward interest. Over the course of your loan term, the scale slowly tips the other way until at the end of the term when nearly your entire payment goes toward paying off the principal, or balance of the loan.
There are differences between the way amortization works on fixed and adjustable rate mortgages (ARMs). On a fixed-rate mortgage, your mortgage payment stays the same throughout the life of the loan with only the mix between the amounts of principal and interest changing each month. The only way your payment changes on a fixed-rate loan is if you have a change in your taxes or homeowner’s insurance. With an ARM, principal and interest amounts change at the end of the loan’s teaser period. Each time the principal and interest adjust, the loan is re-amortized to be paid off at the end of the term.
Fully Amortizing Payments On A Fixed-Rate Mortgage
With a fixed-rate mortgage, your interest rate always stays the same. The only thing that changes is the relative amount of principal and interest being paid month-to-month. At the beginning of the loan, you pay way more interest than you do principal. Over time, the scale tips in the other direction. As an example, see the amortization schedule below for a 17-year loan with a 4.25% interest rate.
Fully Amortizing Payments On An Adjustable Rate Mortgage (ARM)
On an adjustable rate mortgage, you still have fully amortizing payments even though the interest rate can go up or down at the end of the teaser period. The teaser period is how long your interest rate stays fixed at the beginning of the loan. This period is typically 5, 7 or 10 years. When you’re comparing adjustable rate mortgages, it’s important to know what you’re looking at when comparing rates. If you see a 5/1 ARM with 2/2/5 caps, that means that the initial rate will stay fixed for 5 years and change once per year after that. The caps are how much the payment can increase. In this case, the payment could go up 2% on the first adjustment and 2% on each subsequent adjustment. However, in no case can the payment go up by more than 5% over the entire lifetime of the loan. The only thing limiting how much a payment can go down is the margin on the loan, which will be stipulated in your mortgage documentation.
This is not always the case, but it’s common for ARMs to have 30-year terms. The payment re-amortizes over the remainder of the loan so that your balance will be zero at the end of the term.
As an example, here’s an amortization schedule for a 5/1 ARM with 2/2/5 caps with a $300,000 loan amount and an initial interest rate of 4.25%.
What Are Interest-Only Payments?
In contrast to fully amortizing payments, some people opt for loans that only require you to make interest payments for a period of time. These may often be referred to as interest-only mortgages. They can be attractive for people who want to be able to buy a home, for example, but keep a low monthly payment for a while.
There are a couple of different ways these work. Some loans have interest-only payments for a period of time before transitioning to fully amortizing payments for the remainder of the term. For example, if a loan had a 30-year term, the first 10 years might only require the client to make interest payments. After that, principal and interest payments would be made for the remaining 20 years or until the loan was paid off.
In a different type of interest-only loan structure, you only pay the interest for a certain number of years. At the end of that time frame, there’s a balloon payment where all or a portion of the balance is due. If you only have to pay half a portion of the balance, the remainder of the loan payments are typically fully amortized for whatever amount of time remains on the term.
It’s possible to pay off principal while in the interest-only portion of the loan in order to avoid the payment change being such a shock when the loan amortizes over the remainder of the term. If you have a balloon payment to pay off the full balance at the end of the term, paying down the principal can help you lessen the amount you have to pay off or refinance. Just be aware of any potential prepayment penalties.
Fully amortized loans have schedules such that the amount of your payment that goes toward principal and interest changes over time so that your balance is fully paid off by the end of the loan term.
In terms of the benefits, a fully amortized loan gives certainty that you’ll be able to pay off the loan in monthly increments over time and fully pay off the loan by the end of the term.
On the downside, payments are little bit more expensive than they would be with interest-only loans, but you don’t have the payment shock of either a balloon payment or a payment that amortizes over the remainder of the term after a while.
If you’re interested in getting started, you can apply online for a home loan!
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