What Are Amortised Loans And How Do They Work?
updated: Nov 04, 2024
Loan amortisation breaks down your loan into smaller and regular monthly repayments, where you pay both the principal amount and interest accrued. Here's what you need to know about amortised loans and why they matter to you.
written_by SingSaver Team
What is an amortised loan and how does it work?
Essentially, an amortised loan is a type of loan that breaks your loan repayments into equal monthly installments that are spread across a few months or years.
Each monthly repayment will consist of both the principal and interest, with the proportion varying throughout the loan period. For example, if your monthly repayment is S$1,000 and S$400 goes to the interest portion, the excess S$600 is the amortisation that reduces the principal amount.
The interest portion of your repayments will take up a higher percentage in the beginning before gradually decreasing. In contrast, the principal amount is smaller at the initial stage but will increase towards the end of the repayment period.
It’s structured this way because a higher portion of interest payments at the start will help reduce the interest accrued monthly. As the interest accrues reduces, more of each payment will go towards the principal amount under the loan until it’s paid off.
Some examples of loans that follow an amortisation loan structure are fixed-rate home loans, personal loans, and car loans.
What is an amortisation schedule?
An amortisation schedule is a table that details a monthly breakdown of the principal and interest payments until the loan is paid off. The table schedule also shows the remaining balance of the loan after each payment.
Understanding an amortisation schedule helps you understand how your loan is structured, plan your payments, and calculate the interest you’ll pay over the loan's term.
As a hypothetical example, let’s say you took a S$10,000 loan with a 2-year term and at 5% interest. The amortisation table below shows that while the monthly repayments remain at S$438.71, the proportion of interest and principal amount varies throughout the loan period.
Pros and cons of amortised loans
The main benefit of amortised loans is that they make financial planning easier — you know the exact amount you pay each month and throughout the repayment period. Moreover, since you’re making both principal and interest payments, you’ll also gain equity in the asset as you pay off the loan.
On the other hand, the monthly repayments for amortised loans can be quite expensive as you’ll need to make both principal and interest payments.
Some borrowers may also be unaware of the real cost of the loan if they don’t take the interest payments into consideration, even if the monthly repayments might fit their budgets. For example, a longer amortisation period means that your monthly repayments are lower since you have a longer time to repay the loan. However, this also means that you will be paying more interest since it takes more time to lower the principal amount.
Other frequently asked questions (FAQs)
What is negative amortisation?
A negative amortisation occurs when the amount you owe increases instead of decreasing over time, even when you make monthly payments. This is often caused by the failure to cover the interest of the loan, causing the unpaid interest accrue on the unpaid principal balance.
There are a few reasons why negative amortisation can happen; for instance, if you’re on a floating-rate home loan, the changing interest rate might cause your monthly interest rate to increase higher than what you monthly intallment amount can cover.
Should this happen to you, you might be required to pay off the accrued interest or pay an additional installment in your loan tenure. There also might be the need to recreate a new amortisation table with the new installment amount which include the accused interest.
What’s the difference between amortised loans, balloon loans and revolving debt?
In an amortised loan, you pay the interest of your loan as well as the principal amount in each monthly installment, thus reducing your loan amount in each payment.
Ballon loans is a short-term loan where only a portion of the loan’s principal is amortised. At the end of the term, you’ll need to make a large payment.
Meanwhile, a revolving credit is when you borrow against your credit limit, which you can keep borrowing as long as you haven’t reached the limit. There’s no fixed payment amount or loan amount. However, interest will continue to accrue on the debt if it’s not repaid. One example of a a revolving credit is credit card.
Can I pay off an amortised loan early?
Yes you can. Paying off your amortised loan early will help you save on interest charges, lower your total cost of borrowing, and free up some cashflow. However, keep in mind that some bank may charge an early repayment penalty. Also, you may not have the excess funds to invest in other investment opportunities with higher returns.
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SingSaver Team
At SingSaver, we make personal finance accessible with easy to understand personal finance reads, tools and money hacks that simplify all of life’s financial decisions for you.