What is Loan Amortization, Really?
Let’s assume you want to buy a property that costs $1,000,000. How are you going to pay for it?
Are you fortunate enough to have $1,000,000 in the bank and can pay in all cash?
Most people don’t have this luxury and need to borrow a portion of the $1,000,000 in order to make this purchase. You would get a loan and the terms of the loan dictate how much you pay each month and how long you need to pay it back for.
“Promises make debt, and debt makes promises.” — Danish Proverb
- An amortized loan is a type of loan with scheduled, periodic payments that are applied to both the loan’s principal amount and the interest accrued.
- As you continue to make monthly payments, the portion of your fixed payment that goes to interest is less and less and the portion that goes to reducing your loan principal is more and more.
- There are two key differences between Residential and Commercial Real Estate (CRE) loan amortization schedules.
Loan Amortization Definition
“An amortized loan is a type of loan with scheduled, periodic payments that are applied to both the loan’s principal amount and the interest accrued. An amortized loan payment first pays off the relevant interest expense for the period, after which the remainder of the payment is put toward reducing the principal amount.” — Investopedia
Break it Down
“Scheduled, periodic payments” — such as monthly fixed mortgage payments that last 30 years.
“Principal amount” — meaning the size of the loan you need (i.e. a 70% loan would be a $700,000 loan principal amount to purchase a property selling for $1,000,000).
“Interest accrued” — the interest that the lender will make off you for loaning you their money (i.e. 5% annual interest rate paid on the $700,000 you borrow for 30 years).
“Reducing the principal amount” — meaning that at the end of the amortization period the loan will be fully paid back (i.e. Each month you make your mortgage the $700,000 will be gradually reduced until it is $0 at the end of 30 years).
Define it for Me a Different Way
Your fixed monthly mortgage payment is divided into two parts: interest payment and principal payment.
But you see only one fixed number that is paid to the lender each month.
Interest payment is calculated based on your interest rate and your remaining loan balance. Principal payment is the difference between your fixed total mortgage payment and the interest payment.
While your total payment amount stays the same month to month, the interest payment and principal payment changes over time.
As you continue to make monthly payments, the portion of your fixed payment that goes to interest is less and less and the portion that goes to reducing your loan principal is more and more.
- Loan Amount: $700,000
- Loan Term: 30 years
- Loan Amortization: 30 years
- Annual Interest Rate: 5.00%
In the Loan Amortization Table below, I show the first and last 10 months of loan payments (over 360 monthly payments).
This table shows the beginning loan balance, fixed monthly payment, monthly breakdown between the amount of that fixed payment that goes to interest and principal, and then the ending balance of the loan after that fixed monthly payment is made.
Check out the interest portion of the payment and you’ll see it reducing each month and the portion of payment going to principal increasing. At the end of month 360 (end of 30 years), the loan balance is $0 and the property is now owned “free & clear” of any mortgage liability.
What if I make payments larger than the fixed monthly minimum?
If you pay extra each month then 100% of your extra payment will go towards paying down your principal loan balance faster.
Residential vs. Commercial Real Estate
*Residential = 1–4 unit family residences
*Commercial = 5+ unit family residents (apartments), office, retail, hotel, industrial, etc.
Two key differences between Residential and Commercial Real Estate (CRE) loan amortization schedules:
1. Prepayment Penalties
Residential loans typically DO NOT have prepayment penalties so you can pay off your home as fast as you want. Commercial loans may or may not have prepayment penalties depending on the type of deal and the lender.
CRE loans typically have prepayment penalties that make it costly to pay down the debt faster. This will vary between lenders and between financing options at each lender.
2. Term Matching Amortization
Residential loans typically have the same loan term and amortization (i.e. a 15-year term that is paid off in 15 years OR a 30-year term that is paid off in 30 years).
Commercial loan terms more commonly carry non-matching Terms vs their Amortization. Many loans are amortized over 20, 25, or 30 years with terms of 3, 5, or 10 years (the fixed monthly payment is calculated using the amortized period but the remaining principal balance will be due at the end of the term). This is not always the case but is most common for commercial mortgages.
Good luck out there my friends.
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