Explaining the Basics of Loan Amortisation
Loan amortisation breaks down one's loan repayment into consistent, small blocks spread across a few months to few years. It is designed to provide borrowers with an easy to manage mechanism of paying down their loans over time. Payments will be made in regular installments in a set amount that consists of both principal and interest. Common examples of amortized loans include personal loans, car loans and home mortgages.
What Is Loan Amortisation?
Loan amortisation refers to the process in which the principal of a loan is paid down over the life of the loan. Therefore, each month's repayment will consist of interest payment plus principal repayment, the ration of which will change throughout the repayment period. The interest portion generally makes up for the greater portion of monthly repayment at the beginning of the repayment period and will decrease as time goes on. Conversely, the principal portion is less towards the beginning of the repayment period and will increase towards the end.
For example, if a business borrowed S$10,000 for a term of one year at 5% APR (annual percentage rate), its amortization schedule would be the following if it started to repay immediately. As you can see, an amortised loan's monthly repayment remains consistent at S$856.07 during the entire repayment period, but the proportions of principal and interest change over time.
|Payment||Payment Amount||Amount Applied to Principal||Amount Applied to Interest||Remaining Balance|
Pros and Cons of Amortised Loans
An amortised loan is more beneficial for most people. Because amortized loans allow you to pay off both principal and interest at the same time, you gain equity in the asset that is being used as a collateral for the loan, such as a house or a car, with each payment. In addition, each month you know exactly the amount you will be paying since it stays the same. Knowing that your payments won’t change month to month makes financial planning easier and more effective.
One thing to be aware of is that an amortised loans' monthly payments can be quite large because you have to make both interest and principal payments. Another drawback to amortized loans is that many consumers aren’t aware of the true cost of the loan. While the monthly payment of a loan may seem to fit in your budget, you should always calculate the total amount in interest that you will pay to determine the actual cost of taking out the loan.
Most loan types offered in Singapore are amortised, including the following:
Amortised vs. Unamortised Loans
Unlike amortised loans, unamortised loans require the borrower to make interest-only payments during the bulk of the repayment period and end with a balloon payment at the end for the entireity of remaining principal. For some people, unamortized loans are a more attractive option because of the lower monthly repayment that only consists of interest expenses.
Although you aren’t paying any principal at the outset (and as such not gaining equity), unamortized loans provide low affordable payments until you get a large amount of cash. Unamortized loans work best for people who receive sporadic lump-sum payments, such as those who rely on bonuses, commission or contract completion (e.g., real estate agents). Typically, personal line of credit and balance transfers tend to be unamortised. Some education loans are also unamortised as they require interest-only payment for a significant length of time.
Unamortized loans are more straight-forward since you know each monthly payment is only going towards interest. This makes it easier to calculate the actual cost of the loan. The trade-off for lower interest-only payments is that towards the end of the repayment period, you will have a large balloon payment to payoff the entirety of original principal that you borrowed. Planning ahead is crucial to ensure that you don’t become delinquent given the change in payment amount.
Knowing how much you will pay every month and how much total interest you will pay is important in making any borrowing decisions. This information will help you determine if the cost of the loan is actually worth it for your needs.