Loan amortization is the way lenders guarantee they will fulfill their financial obligations to the borrower. In this article, we'll show you how to manage it successfully.
Before loan amortization, what is a loan?
The first thing you should know before delving into the subject is the concept of a loan. This is nothing else but the financial operation that is carried out between a person who requires some type of financing and a financial entity that grants it.
The loan or credit operation, as it is also often called, receives this connotation by establishing the obligation of the borrower to repay the total amount of the financing received, plus the additional remuneration to the lender for it, within a certain period of time.
As we can see, the loan has advantages for both parties. Firstly for the borrower, who receives immediate financing once the operation is approved and secondly for the lender, who receives a remuneration in relation to the amount of capital granted in financing.
In the loans, some conditions of strict compliance by the borrower are required that have to do with the periodicity of the payment of installments for the financing obtained.
We invite you to read our article on loan requirements where you will find more useful information.
What is a loan amortization?
Precisely, these installments that we pay periodically, comply with a part of the financed capital and another part with the interest for said financing. This procedure of periodic payment of installments is what is known as loan repayment.
Generally, business managers use loan repayment as an exploratory tool for evaluating risk management in projects under development. As the evaluation is positive for the entrepreneur, a sufficiently detailed detail of the net present value and the internal rate of return on investment through external financing can be obtained.
What are the advantages of loan amortization?
You should know that the amortization of loans constitutes numerous advantages for the borrower, the most significant being that it corresponds to the cancellation of financing capital installments.
That means that for each amortization that we make, we end up owing less capital to the lender. Consequently, the calculation of the following interests will be reduced in relation to the remaining capital to be paid.
Likewise, we can make extra amortization installments that will have a very positive effect. Well, depending on the type of prior agreement during the credit agreement operation, when making extra amortizations, we reduce future installments in amount of money or in number of remaining installments to cancel.
This last amortization process is usually called early amortization and implies greater benefits for the lender. And it is that by canceling your debt installments in advance, you will be able to ensure, first of all, return less money than expected.
As a second benefit of early repayment, is that if our undertaking yields the expected results, in each future repayment we will obtain greater profitability.
And as a third benefit and best of all benefits, by reducing loan terms or installments, we will achieve greater peace of mind by seeing the pressure of acquired obligations decrease.
What conditions must be met to make loan repayments?
Amortization as a process must comply with a series of elements in order to be able to calculate it correctly. These elements are the following:
Capital
The capital corresponds to the amount of money allocated by the lender for the financing of our enterprise. Likewise, it includes the obligation for which the lender must be paid a periodic amount of interest.
amortization fee
The amortization fee is the term with which we define the amount of money that periodically, according to the terms and conditions of the loan, we must repay the lender.
Generally, these periods are monthly, quarterly or semi-annually, depending on the type of loan and its amount. These amortization installments have a capital part and another part in interest, according to the type of amortization that we have agreed upon at the beginning of the credit operation.
Active capital of the loan
The active capital of the loan is the part of the financing that remains pending to be canceled to the extent that we are making the corresponding amortizations.
We must bear in mind that this term is not coined to the amount of outstanding debt, since it only applies to the capital and not to the interest to be paid.
Amortized capital
The amortized capital is the term we use to refer to the amount corresponding to the capital of the debt that we have honored through the periodic amortization installments actually made.
Interest
Interest is the term that corresponds to the remuneration that we must pay to the lender for the financing obtained. The amount is calculated based on a percentage of the capital approved for financing.
It is worth noting that the interest may vary according to the previous conditions of the loan. In the case of loans where amortizations have been made, the amount of interest decreases to the extent that the active capital of the loan decreases.
In the event that the repayments are for fixed amounts during the term of the loan, you should know that the participation of the interest fee in the repayment fee decreases and the capital fee increases.
Loan Amortization Tables
When applying for a loan, we must be attentive to the amortization table or table. This is nothing more than a detailed list of calendar dates where the amounts of capital and interest that must be assumed are appreciated. In them, the amount of capital and amortized interest and those that remain assets to be honored on certain dates must be reflected in the same way.
It is worth noting that an amortization table can have different implications that will basically depend on the interest rate negotiated in the credit operation. These are detailed below:
If the interest rate agreed in the operation is a fixed rate, we will be able to notice that the amortization table will be final and real from the first moment it is calculated, so it will be the table or table that will be applied from the granting of the credit. .
If, on the contrary, the interest agreed in the credit operation is of the variable rate, the amortization table will be of reference but not the definitive one. This will show the behavior of amortizations to the extent that the interest rate presents the expected variations.
Whatever the implication, you must be clear that the financial institution that will grant you the loan is obliged to provide you with this information and in the event that the interest is of the variable rate, you must request the periodic updating of the table.
Types of Loan Amortization
Loan amortizations can be made in different ways. These will depend on the prior agreement between the parties at the time of agreeing on the credit operation.
We must clarify that the type of amortization does not imply any variation in terms of the final amount to be paid by the person who receives the financing. However, if it can represent some type of advantage in terms of the ease of payment to be made by the lender.
Choosing the loan repayment method will depend mainly on the ease offered to the loan applicant, the periodic cancellation of the repayment installments. Therefore, we present the most common.
Amortization of loans using the French method
The most widely used and universally accepted method is the French method of loan repayment. Basically, this method consists of setting and canceling periodic installments of the same amount by the borrower.
These installments, as they occur, modify the share of capital and interest therein, without altering the total to be paid. It is important to point out that during the first installments, the amount of interest will be greater than the amount of principal, while in the final installments, the relationship will be vice versa, that is, the amount of principal will be greater than the amount of interest.
It is worth noting that the setting of quotas obeys financial rules for its calculation that will determine the payment of a constant amount of money. For this, it is necessary that the interest rate of the financing be fixed during the term of the loan. In the case of taking a variable interest rate, the installments will be constant in the periods of time in which said interest rate does not present variation.
The most notable example of this type of amortization corresponds to mortgage loans. In these you can see how in the first installments a large amount is paid for interest that will decrease over time. For this reason, many people, when requesting a statement of debt in the medium term, are surprised to verify that most of the capital seems intact.
Advantages and disadvantages
As we can see, the main advantage of this type of amortization is that, if we manage the amortization table, we will know in advance the amount paid for capital and interest and what will be pending to be paid. Likewise, another advantage is that as time goes by and depending on inflation levels, we will appreciate that the amount of the fee will become more and more accessible to honor.
The main disadvantage is that most of the initial installments will be used to cancel the interest on the loan, so it will be perceived in the first periods that the capital will remain almost intact.
Let's see an example with easy-to-use figures for your understanding; Suppose we have a loan for $50.000 with a financial institution that establishes a fixed interest rate of 3% per year, to pay it off within 5 monthly installments.
| Months | Registration fees | Amortization | Interest | Outstanding Capital |
| 1 | $10.075,12 | $9.950,12 | $125,00 | $40.049,88 |
| 2 | $10.075,12 | $9.975,00 | $100,12 | $30.074,88 |
| 3 | $10.075,12 | $9.999,93 | $75,19 | $20.074,95 |
| 4 | $10.075,12 | $10.024,93 | $50,19 | $10.050,02 |
| 5 | $10.075,12 | $10.050,02 | $25,10 | $0,00 |
| Total | $50.000,00 | $375,60 | ||
We can see that using this method, the odds remain fixed at $10.075,12; This amount results from the distribution of the amortization installments of the financed capital and the corresponding interest, which varies with each installment effectively paid inversely; the first installment has a higher contribution of interest, while in the last, this love is less than the capital.
Amortization of loans using the German method
Also known as the constant amortization method. The German method of loan amortization is also a widely used method in the credit operations of financial institutions, most frequently in mortgage loans.
It is particularly characterized by the constant amortization of a fixed installment of capital of the financing that we have obtained, while the interests vary depending on the outstanding capital of the loan.
Based on this, we can determine three fundamental characteristics in this type of loan repayment. In the first place, the constant installments of periodic amortization of capital. Next, the decreasing interest rate over time and therefore, the third characteristic of it, will be that of decreasing total installments.
An additional peculiarity of this system is that the payment of interest is made in advance in each installment, since they are calculated in relation to the outstanding capital of the loan, which decreases over the course of the term of the credit.
Advantages and disadvantages
Like any repayment method, this one has some very significant advantages for the lender. Among these, there is the undeniable fact that halfway through the credit period, we will have already paid half of the capital of the financing obtained. Likewise, as time progresses, each installment will become less, which makes it possible to perceive that less would be paid, although this is not the case.
However, this method has some disadvantages, although in contrast to the advantages, they are not of great importance. These are, in the first place, the perception of very high installments at the beginning of the term of the loan and the second, it is not recommended for making early repayments since interest is paid based on all the living capital.
The difference between this method and the previously explained French method lies in the calculation of interest and its form of payment during the course of the loan; likewise, in the constant capital quota that is canceled in each amortization.
Continuing with the previously mentioned example, where we suppose that we have a loan for $50.000 with a financial entity that establishes a fixed interest of 3% per year, to cancel it within 5 monthly installments, we can recalculate the amortization table under this method. and we will get the following results: