When you take out a loan, you pay to the bank on a monthly basis. You might think that these payments are split evenly across the term of your loan, but this isn’t exactly the case. The amortisation of your loan is based on how much you borrow and on how long it takes you to repay it.
It’s important to understand about amortised loans so that you don’t have any nasty surprises when arranging new borrowing.
What is amortised loan?
The frequency with which you make repayments is often referred to as the amortisation schedule. For instance, if you are taking out a fixed rate loan of £100,000 that is repaid over 25 years, it would be referred to as an ‘amortised’ loan.
It’s the interest rate, not the time-scale, that is important when interpreting your amortisation schedule. So, if you borrow £100,000 at a rate of 6%, this would be equivalent to an interest rate of 0.6% per annum.
Another way in which the interest rate is expressed is as APR (annual percentage rate). It’s called this because it’s calculated on a yearly basis and takes into account the amount of your loan that you have borrowed and any additional amounts (usually known as fees) that may be involved.
The amortisation schedule shows how often payments are made over a term, expressed as a number of months. Amortised loans are usually expressed in monthly instalments repayable over a fixed period, such as five years in advance or 25 years in total.
How amortised loans are calculated?
To calculate the amortised schedule, both the amount of your loan and the interest rate being charged have to be taken into account. For example, if you borrow £100,000 at 6% over 25 years, then this would work out as £3,917.50 per month in repayments (calculated below).
This is how it is calculated:
£100,000 × 6% × 25 years = £3,917.50
But remember that this is not how much you actually pay each month because it has been based on an APR of 0.6%. So, the total amount of interest you will pay will be £45,175. The actual monthly repayment is £3,917.50 – £45,175 = £3960.50
To calculate the exact monthly payment made on a 25-year loan at an interest rate of 6%, use this formula:
100000 x 6 / 1297 = 3960.5
Please take note that for a loan of this size and at these rates, a full 25 years would need to be undertaken to get the most accurate picture.
Example: You borrow £100,000 at an interest rate of 6%. The amortised payment made will be £3960.50 every month over a period of 25 years.
What is APR?
APR stands for Annual Percentage Rate. It’s a way of comparing charges in a simple number and allows borrowers to compare loans offered by different lenders.
However, it doesn’t take into account what period of the year you’ll be repaying your mortgage and this can make a big difference to your total repayments.
A common way of presenting APR is as an annual percentage rate (APR). So, for example, you borrow £100,000 at 6% over 25 years and the APR is 8%. Then, it would be expressed as 0.08% per annum.
The APR can also be described as interest cost divided by the effective term of your loan. This effectively works out how each payment works out when compared for a certain period of time. If you’re borrowing £100,000 from a bank for 30 years at 6%, then you’ll pay back £64,884.
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When is the loan paid off?
The advantage of having monthly repayments is that you get to see exactly how much you are paying each month and when your debt will eventually be cleared.
If your loan doesn’t fully amortise over the term, then it might not clear till after this time has elapsed. In our example above, it was assumed that the entire amount was paid off after 25 years, but this would not always be the case.
What if you don’t want to wait that long? If you need to make a lump sum payment but don’t want to wait the full 25 years, then you can pay off what’s left of your loan at a lower rate.
This often happens in cases where there is a prolonged economic slowdown which leads to a reduction in the value of property prices. The reduced amount that you can borrow means that fewer repayments are required and it’s possible that only some of the original amount would be paid off when the loan has finally cleared.
It is also likely that this would be paid off at an interest rate lower than originally agreed. It therefore lowers the amount you still owe for any missed payments.
How does amortisation work?
Repayments are normally paid evenly over the term of the loan, but the actual amount owed at any point in time is more complicated. When you take out a loan, you will normally be charged interest on your outstanding balance in addition to your capital sum.
As time passes and the loan is repaid, your capital sum decreases. However, your interest rate will remain the same throughout the term of your loan. So, the amortised schedule shows how this affects your monthly repayments.
It works like this: over time, you’ll be paying off more capital than interest as you gradually pay down what you originally borrowed. In effect, each month you are paying a percentage of your outstanding balance on top of the amount to clear what you originally borrowed.
Our example above showed that the monthly repayment for a 25-year loan was £3960.50. Though, the actual amount you would pay isn’t this figure multiplied by 24 (the number of months in any given year). That’s because more of your payment is being used to cover interest than capital.
This difference is easily seen if you compare an amortising loan with an APR breakdown. In our example above, the amortised repayment worked out as £3,917.50 over a fixed 25-year term. As we saw above, this actually consisted of interest at 6% and £3960.50 – £45,175 = repayments at 0.6% per annum.
When calculating the amount you need to borrow, always include a margin for interest. How much you need to borrow is dependent on the interest rate, total amount borrowed and the length of time you will be repaying it.
Interest rates have fallen and it’s easy to get bank accounts with lower rates. But, that doesn’t mean that you can afford to take on even more debt. It’s important when comparing loans, to make sure you are comparing like-for-like loans.
If in doubt, speak to your mortgage broker who can help ensure that you are getting the best deal overall by comparing all aspects of your loan before making a decision.