Amortizing loan
Encyclopedia
In banking and finance
, an amortizing loan is a loan where the principal of the loan is paid down over the life of the loan, according to some amortization schedule
, typically through equal payments.
Similarly, an amortizing bond is a bond
that repays part of the principal (face value
) along with the coupon
payments. Compare with a sinking fund
, which amortizes the total debt outstanding by repurchasing some bonds.
Each payment to the lender will consist of a portion of interest and a portion of principal. Mortgage loan
s are typically amortizing loans. The calculations for an amortizing loan are those of an annuity
using the time value of money
formulas, and can be done using an amortization calculator
An amortizing loan should be contrasted with a bullet loan
, where a large portion of the loan will be paid at the final maturity date instead of being paid down gradually over the loan's life.
An accumulated amortization loan represents the amount of amortization expense that has been claimed since the acquisition of the asset.
Credit risk: First and most importantly, it substantially reduces the credit risk
of the loan or bond. In a bullet loan
(or bullet bond), the bulk of the credit risk is in the repayment of the principal at maturity, at which point the debt must either be paid off in full or rolled over. By paying off the principal over time, this risk is mitigated.
Interest rate risk: A secondary effect is that amortization reduces the duration
of the debt, reducing the debt's sensitivity to interest rate risk
, as compared to debt with the same maturity
and coupon rate. This is because there are smaller payments in the future, so the weighted-average maturity of the cash flows is lower.
(WAL), also called "average life". It's the average time until a dollar of principal is repaid.
In a formula,
where:
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, an amortizing loan is a loan where the principal of the loan is paid down over the life of the loan, according to some amortization schedule
Amortization schedule
An amortization schedule is a table detailing each periodic payment on an amortizing loan , as generated by an amortization calculator. Amortization refers to the process of paying off a debt over time through regular payments...
, typically through equal payments.
Similarly, an amortizing bond is a bond
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
that repays part of the principal (face value
Face value
The Face value is the value of a coin, stamp or paper money, as printed on the coin, stamp or bill itself by the minting authority. While the face value usually refers to the true value of the coin, stamp or bill in question it can sometimes be largely symbolic, as is often the case with bullion...
) along with the coupon
Coupon (bond)
A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures. Coupons are normally described in terms of the coupon rate, which is calculated by adding the total amount of coupons paid per year and...
payments. Compare with a sinking fund
Sinking fund
A sinking fund is a fund established by a government agency or business for the purpose of reducing debt by repaying or purchasing outstanding loans and securities held against the entity. It helps keep the borrower liquid so it can repay the bondholder....
, which amortizes the total debt outstanding by repurchasing some bonds.
Each payment to the lender will consist of a portion of interest and a portion of principal. Mortgage loan
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
s are typically amortizing loans. The calculations for an amortizing loan are those of an annuity
Annuity (finance theory)
The term annuity is used in finance theory to refer to any terminating stream of fixed payments over a specified period of time. This usage is most commonly seen in discussions of finance, usually in connection with the valuation of the stream of payments, taking into account time value of money...
using the time value of money
Time value of money
The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory....
formulas, and can be done using an amortization calculator
Amortization calculator
An amortization calculator is used to determine the periodic payment amount due on a loan , based on the amortization process....
An amortizing loan should be contrasted with a bullet loan
Bullet loan
In banking and finance, a bullet loan is a loan where a payment of the entire principal of the loan, and sometimes the principal and interest, is due at the end of the loan term. Likewise for bullet bond...
, where a large portion of the loan will be paid at the final maturity date instead of being paid down gradually over the loan's life.
An accumulated amortization loan represents the amount of amortization expense that has been claimed since the acquisition of the asset.
Effects
Amortization of debt has two major effects:Credit risk: First and most importantly, it substantially reduces the credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
of the loan or bond. In a bullet loan
Bullet loan
In banking and finance, a bullet loan is a loan where a payment of the entire principal of the loan, and sometimes the principal and interest, is due at the end of the loan term. Likewise for bullet bond...
(or bullet bond), the bulk of the credit risk is in the repayment of the principal at maturity, at which point the debt must either be paid off in full or rolled over. By paying off the principal over time, this risk is mitigated.
Interest rate risk: A secondary effect is that amortization reduces the duration
Bond duration
In finance, the duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received....
of the debt, reducing the debt's sensitivity to interest rate risk
Interest rate risk
Interest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...
, as compared to debt with the same maturity
Maturity (finance)
In finance, maturity or maturity date refers to the final payment date of a loan or other financial instrument, at which point the principal is due to be paid....
and coupon rate. This is because there are smaller payments in the future, so the weighted-average maturity of the cash flows is lower.
Weighted-average life
The number weighted average of the times of the principal repayments of an amortizing loan is referred to as the weighted-average lifeWeighted-Average Life
In finance, the weighted-average life of an amortizing loan or amortizing bond, also called average life, is the weighted average of the times of the principal repayments: it's the average time until a dollar of principal is repaid....
(WAL), also called "average life". It's the average time until a dollar of principal is repaid.
In a formula,
where:
-
is the principal, -
is the principal repayment in coupon 
, hence -
is the fraction of the principal repaid in coupon 
, and -
is the time from the start to coupon 
.
See also
- Amortization calculatorAmortization calculatorAn amortization calculator is used to determine the periodic payment amount due on a loan , based on the amortization process....
- Amortization scheduleAmortization scheduleAn amortization schedule is a table detailing each periodic payment on an amortizing loan , as generated by an amortization calculator. Amortization refers to the process of paying off a debt over time through regular payments...
- Amortization (business)Amortization (business)In business, amortization refers to spreading payments over multiple periods. The term is used for two separate processes: amortization of loans and amortization of intangible assets.-Amortization of loans:...
- Sinking fundSinking fundA sinking fund is a fund established by a government agency or business for the purpose of reducing debt by repaying or purchasing outstanding loans and securities held against the entity. It helps keep the borrower liquid so it can repay the bondholder....
- Weighted-Average LifeWeighted-Average LifeIn finance, the weighted-average life of an amortizing loan or amortizing bond, also called average life, is the weighted average of the times of the principal repayments: it's the average time until a dollar of principal is repaid....