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Thursday, February 10, 2011

Understanding the loan amortization schedule

A loan amortization schedule is a repayment plan that is calculated before repayment of a loan begins. Typically, amortization schedules are used for fixed interest long-term loans such as mortgages and are recorded on spreadsheet using interest rate calculation software or hand calculation.

The information included on an amortization schedule often consists of columns and rows that include payment dates or periods, declining balance amounts, interest rate and payment amounts. Amortization schedules can either be non-compounded or compounded although the latter is the more likely to be used by various financial institutions.

Non-compounded amortization schedules

A non-compounded amortization schedule is calculated by dividing a total loan amount by a pre-determined repayment plan with or without interest. For example, a no interest loan such as a medical deductible may be broken down into standard fixed payments or perhaps in some cases with graduated i.e. increasing payments.

Standard payments would divide the loan balance equally by the number of payments whereas graduated payments would increase by a fixed amount thereby gradually becoming larger. Those payments are then listed side by side on the amortization schedule with declining balances and payment dates or periods.

A non-compounded amortization schedule with interest is calculated without subtracting periodic interest paid to a loan balance. Rather, the interest on the loan, if any, is calculated one time and then divided among the remaining payments. For example, a loan in the amount of $167,000.52 at an interest rate of 5.75% would have an interest payment of $9602.53.

Since the interest is not being compounded over time, the interest may be divided equally or unequally by the length of the loan depending on the terms of the loan. So if the loan terms are for 15 years, with monthly payments the interest amount will be $53.35 per month. This type of amortization is more cost effective and harder to acquire than a compounded amortization schedule because the total amount of interest is front end rather than continual i.e. the total interest is calculated once rather than 180 times as is the case in compounding.

How reverse compounded amortization schedules are calculated

A more common type of amortization schedule begins with the starting loan balance and an interest rate to determine first payment and then reverse compounds i.e. the subsequent payments will be lower because the principal balance on which interest is calculated is lower.

For example, with a starting balance of $167,000.52 at a fixed interest rate of 5.75% the annualized interest will be $9602.53. If the loan repayment terms are schedule to be annual then $9602.53 will be due in the first year. However, if the payments are monthly, which is more common, the first payment will be determined by dividing $9602.53 by 12 since there are 12 months in a year. So, for a monthly schedule, the first payment due will be $800.21.

Since amortization schedules use reverse compounding, the remainder of the payments will not be $800.21 as would be the case with an amortization schedule that does not compound. In the case of reverse compounding the first payment of $800.21 is deducted from the principal balance of $167,000.52 to make the new balance $166,200,31. Then the second month's interest is calculated on the new balance i.e. 5.75% of $166,200,31 for a second payment of $796.38 or $9556.62/12 using annualized interest. This method of amortization will end up costing more because the interest is calculated for each month of repayment rather than one time only.

Amortization schedules serve multiple purposes. Those purposes include assisting financial institutions and borrowers in negotiating or calculating repayment terms, providing a digital and/or paper record of agreement and allowing financial institutions to generate added revenue using reverse compounding.

Amortization schedules usually have columns in which payment periods or dates are in one column, declining balance is in a second column, interest calculated is in another column and then the new balance is in the last column and carried forward to the next line of the declining balance column.
Amortization is often calculated using reverse compounding which allows a greater amount of interest to be charged to the lenders. When this method of amortization is used it is to the borrowers advantage to pay the loan off in as short a term as possible.