When you borrow money, such as taking out a car loan or a personal loan to fund your ventures, the lender expects you to repay the borrowed amount over a specified period. The repayment structure is usually divided into instalments, commonly monthly, and includes both a portion of the principal and accrued interest. This is a simple concept that is familiar to many, but not many know what it is called – amortisation.
In this article, we will look at what amortisation is exactly, for borrowers, some of the benefits of this structure, and how it works. We will also discuss what an amortisation schedule is and some factors that borrowers should be mindful of when setting one up. If you would like more guidance on how to set up an instalment plan, you can visit Enklare.
What is amortisation?
In the context of loans and money borrowing, amortisation is the process of paying a loan off over time through regular instalments. These instalments typically include both the principal amount borrowed and the interest accrued over time.
How amortisation works – for borrowers
When you take out a loan, you may have to agree to an amortisation schedule. This schedule outlines the specific details of each payment, such as a breakdown of each payment between interest and the principal amount.
For many borrowers, it is typical at the initial repayment stages for a larger portion of the payment to go toward interest and the smaller portion to apply to the principal. This is because the interest is a percentage of the principal amount, and at the beginning, the outstanding balance of the principal is at its largest.
Gradually, as the loan progresses, the ratio gradually shifts. A larger portion of each payment is used to reduce the principal balance instead.
Why amortise?
The primary reason for amortisation is to ensure the loan is fully repaid by the end of the loan term, working on the assumption that all payments are made as scheduled. By creating and following an amortisation schedule, you as a borrower can budget for regular payments and gradually reduce your outstanding debt over time.
Benefits of amortisation – for borrowers
Amortisation also comes with several benefits for borrowers, such as:
Having a structured repayment plan
Borrowers can make regular and predictable payments over the loan term, making it easier for them to stay on top of their debts.
Gradually reducing debt
Borrowers can reduce their outstanding debt over time instead of all at once, increasing their financial flexibility.
Potentially paying less interest
Borrowers can potentially reduce their interest costs – as the principal balance decreases, the interest charged on the remaining balance also decreases. Compared to other forms of repayment, such as interest-only payments, this can result in lower interest paid.
Potentially enhancing borrowing capacity
Amortisation can also improve the borrower’s capacity to take out loans by spreading out repayments, as repayment can be done over a long period. Since each payment is lower compared to a shorter-term loan, borrowers may qualify for larger loan amounts while still maintaining manageable monthly repayments.
Building credit history
Finally, borrowers who successfully repay an amortising loan can help borrowers build a positive credit history. This is because consistent on-time repayment demonstrates financial responsibility, which can improve credit scores.
Benefits of amortisation – for lenders
For lenders, the biggest benefit of amortisation is that it protects their interests by ensuring the loan is repaid on time. This can lower the risk of default on the borrower’s part, and lenders can earn an income throughout the loan term.
How to create an amortisation schedule
If you are a borrower who wants to create an amortisation schedule, understand that it will involve a series of calculations to determine the payment amount, interest portion, principal portion, and remaining balance for each period. Here is a walkthrough of how you can create an amortisation schedule, knowing that each loan is different, and no two borrowers have the same financial circumstances.
Gather information on the loan
The first step for borrowers is to collect all relevant information about the loan they just took out or will soon take out, including the principal amount borrowed, interest rate, loan term, and the start date of the loan.
Determine the frequency of repayment
Next, decide on the frequency of payments, such as monthly, quarterly, or annually. Monthly repayments are popular for many borrowers.
Calculate the monthly interest rate
To calculate the monthly interest rate, borrowers can divide the annual interest rate by the number of payment periods in a year. For example, if the annual interest rate is 5% and you would like to make monthly repayments, your monthly interest rate would be 5% divided by 12 months, which is 0.417%.
Calculate the total number of repayments
To calculate the total number of repayments, borrowers can multiply the number of years in the loan term by the number of repayment periods in a year. Carrying on from the previous example, if your loan term is 30 years and you are on a monthly repayment schedule, you would be making 360 repayments.
Calculate each repayment amount
To calculate each repayment amount, you can use a loan calculator to simplify the process. Many lenders and loan comparison providers have an amortisation calculator on their website to calculate the repayment amount.
Set up and fill in the schedule
Once you have considered all the relevant information about your loan, you can create a spreadsheet to organise your amortisation schedule. Include columns for the repayment number, date, amount, interest portion, principal portion, and remaining balance. Once that is set up, you can fill in the schedule. Remember to review and verify your calculations to ensure accuracy, and make sure that the remaining balance reaches zero by the end of the schedule.
The bottom line
Amortisation refers to the process of gradually paying off a debt over time through regular repayments. In general, it’s essential to note that the benefits of amortisation depend on its terms and information about the loan. You should always carefully review your loan agreement before you borrow money, as failure to repay your loans can lead to serious consequences including legal action taken against you by your lender.
