Whether it was to pay for school, an engagement ring for the love of your life, the down payment for your first home, or a new car when it was finally time to upgrade, it’s likely that at this point in life, you’ve taken out a loan or two.
You’ve likely noticed that most loans follow a traditional payment schedule. This is known as amortization and tells borrowers how much of their payments are going to the loan’s interest and principal balance. Amortization’s aim is to make sure the loan balance reaches $0 by the end of the loan term.
What you may not know is that there are also loans available that allow you to make interest payments during the first few years. They’re called interest-only loans. In this post, we’ll go over the details and key differences between amortized vs. interest-only payment schedules.
What is an amortized payment?
Also known as an installment loan, amortized loans require equal monthly payments over a predetermined amount of time. Every month, a portion of the payment goes toward the principal of the loan, and another part goes toward the interest.
During the time the investment is active, investors receive consistent and equal payments as previously defined in the amortization schedule. This allows for the investment amount plus interest to be completely settled by the end of the loan’s term.
The interest of an amortized loan is known as amortized interest. With this kind of interest, you’re paid equal amounts monthly. A portion of the money will go toward interest and another part toward principal. The funds that go toward the principal are responsible for decreasing the balance of the loan.
Amortized payments on fixed-rate loans allow borrowers to pay down the loan’s principal and interest at the same time via one fixed monthly payment. As the payment schedule progresses and more payments are made, less goes toward interest, and more starts to go toward the loan’s principal.
There’s also such a thing as partially amortized loans. These loans are also paid in installments, but a balloon payment is also made at the beginning or end of the loan.
What is a repayment schedule?
Amortization schedules sound a lot more intimidating than they are. They’re essentially just tables showing how much of each payment goes toward the loan’s principal, how much goes toward interest, how much time is left on the loan (term to maturity), and the loan’s new balance.
What is an interest-only loan?
Unlike amortized loans that pay down both interest and principal, interest-only loan payments only cover the interest that’s accruing on the loan. So, interest-only loans don’t work toward paying down the loan balance at all – only the interest.
At the end of the interest-only loan’s term, a few options are available to the borrower:
- Make a balloon payment.
- Refinance into a different loan structure.
- If it’s an interest-only mortgage loan, the borrower can sell the home to pay off the loan’s principal.
These loans are ideal for people with stable income such as:
- Small business owners and other people with large but irregular income streams.
- High net worth individuals who want to borrow money and take advantage of their liquidity.
- College grads who are anticipating a high income.
Interest-only payments: pros and cons
Interest-only payments and amortized payments both have their own unique sets of pros and cons. Understanding these pros and cons can help you feel empowered to determine which loan type best fits your goals and risk tolerance. The pros of interest-only loans include:
- Excellent choice for investors looking for high cash-on-cash yield on their investments.
- The potential for buyers to get involved with more expensive properties with higher returns.
- Lower monthly payment for borrowers.
- Lower costs all-around.
- Great for short-term properties.
The cons include:
- The principal investment is tied up for the investment’s lifetime.
- Not the best choice for investors seeking liquidity.
- These payments are riskier.
- There’s no equity.
- Payments are temporary.
Fully amortized vs. interest-only payments
Amortized payment schedules include payments toward the interest and principal. But, interest-only loans—as the name suggests—only pay the interest. For this reason, these loans often have lower monthly payments. But, of course, the balance of the interest-only loan will need to be paid in full eventually through a lump sum (balloon payment). You might also pay the principal by converting the loan to an amortized loan with larger monthly payments that put money toward the principal and the interest.
Borrowers can also refinance their interest-only loans into a different type of loan in order to start paying down the principal in addition to the interest.
Suppose a loan lets the borrower make initial payments for less than their fully amortized payment amount. In that case, the fully amortized payments will be substantially higher eventually, which is typical of most adjustable-rate mortgages (ARMs).
Frequently Asked Questions (FAQs)
What is a fully amortized loan?
Fully amortized loans have a set repayment amount and timeframe that lets the borrower pay back their principal and interest over time.
What is an amortization schedule?
Amortization schedules illustrate how borrowers’ payments are applied to a loan’s principal and interest over time. The bulk of interest payments for fully amortized loans are made earlier in the loan’s terms, and more of the payment goes toward the principal as the end of the loan gets closer.
Can I pay off a fully amortized loan early?
It varies from vendor to vendor. But, in general, vendors allow for fully amortized loans to be paid off early, allowing the borrower to save money on interest payments. It’s important to keep in mind that some lenders have prepayment penalties in place to recoup any lost interest from borrowers who pay off their loans early. So, it’s best to check with your lending institution before paying off the fully amortized loan early.
Understanding repayment schedules is critically important for smart investing and to make sure your money is working harder to produce gains, especially when it comes to real estate investing. That’s why it’s so important to fully grasp all aspects of things you invest in, especially the parts that involve how you’ll get a return on your initial investment.