How loans are repaid

To amortize a loan is to pay it down through regular payments. Each payment is split between interest (the lender's charge) and principal (repaying the amount borrowed). How that split is set up decides what happens to the balance. Unit 14 covers the arithmetic; this lesson covers the types.

Fully amortized

A fully amortized loan has payments calculated so the loan is completely paid off by the end of the term. With a fixed-rate loan, the principal-and-interest payment stays the same each month, but the split changes:

• Early on, most of each payment is interest, because interest is charged on a large balance.
• Later, more of the same payment goes to principal.

This is the standard 15- or 30-year home loan.

Partially amortized, with a balloon

A partially amortized loan has payments that reduce the principal, but not enough to pay it off by the end of the term. The unpaid balance comes due in one large final payment, called a balloon payment. Balloon loans often run 5 to 10 years.

The low monthly payments are the appeal; the risk is the lump sum at the end. A borrower who cannot pay it or refinance can lose the property to foreclosure.

Interest-only

With an interest-only loan, the payments cover only the interest for a set period. The balance does not go down during that time. When the period ends, the borrower must pay off the balance, refinance, or start making larger payments that include principal.

Borrow $250,000 interest-only for 5 years and make every payment: you still owe $250,000 at the end of year 5.

Negative amortization

Negative amortization happens when the payment is less than the interest due. The unpaid interest is added to the balance, so the borrower owes more over time even while making payments, and then pays interest on that added interest. Later payments usually have to rise to cover both principal and interest.

The danger is that the owner can end up owing more than the home is worth, which makes selling or refinancing hard.

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