Fully Amortized Loan: A Definition

Whether you’re 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.

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 word 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 fixed-rate period. Each time the principal and interest adjust, the loan is re-amortized to be paid off at the end of the term.

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.

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 initial fixed-rate period. The initial 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.

A fully amortized loan allows you to budget more easily because you know how your monthly loan payment is divided up. Assuming you choose a fixed-rate mortgage, you’ll always know what your mortgage payment will be over the life of the loan.

A big disadvantage of fully amortized loans is that they require you to pay much of the interest upfront particularly within the first five years of the loan. This means that if you sell your home within a few years, you won’t have much to show in terms of equity.

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.

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. Rocket Mortgage does not offer interest-only loans.

What is an amortization schedule?

An amortization schedule shows how the borrower’s payments are broken down over the life of the loan. As mentioned previously, the majority of the payments for the first five years of the loan goes to interest.

Can I pay off a fully amortized loan early?

Paying off a fully amortized loan early can help save you money on interest. Be sure to see if your lender charges a prepayment penalty in the event that you pay off your loan early.

What is a good example of a fully amortized loan?

Fully amortized loans are usually home loans, auto loans or personal loans. They can be secured (backed by the borrower’s assets) or unsecured.

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.

If you’re interested in getting started, you can get preapproved for a home loan from Rocket Mortgage®!