Loan amortization is simply the process of a borrower paying back the borrowed money in installments and thus decreasing the outstanding loan amount, or principal. This is in contrast to a loan where the borrower pays back the full amount in one payment. The main effect of loan amortization is reduced risk for the lender, both in terms of the likelihood of repayment and the effects of interest rates.
An amortizing loan is one in which the borrower makes regular repayments. Usually, these repayments cover both a chunk of the loan amount, or principal, plus an interest payment. While the principal repayment amount is fixed, the interest repayment may not be. For example, a personal bank loan usually has a fixed interest rate, meaning the amount paid towards interest each month is the same throughout the loan period. With a mortgage, the interest rate is usually variable, meaning the repayment amount can change significantly. It’s also possible to have a fixed interest rate, but different interest payment amounts. For example, in loans where each interest payment is based on the current outstanding debt, not the full loan amount, the interest payments will decrease over time.
The main benefit of loan amortization to a lender is reduced credit risk. This is simply because if a borrower does default, the lender will already have all the money that has been repaid. This is contrast to an all-or-nothing situation, where there is a single repayment. The fact that the outstanding debt decreases during the loan period also means a lender in a fixed-rate loan faces a continually decreasing exposure to interest rate risk. This means there is less danger that she will lose out if interest rates rise, and thus isn’t getting the best possible return available from lending money.
The purest form of loan amortization is where the principal repayments are split equally over the loan period. This doesn’t have to be the case, though. In some cases, the actual payment amount changes from month to month. In other cases, such as many mortgages, the payment amount is the same, but the proportions of the payment that go toward repaying the balance and paying interest change. Commonly, the proportion going toward interest will be higher at the start of the loan.
The contrast to loan amortization is usually referred to as a bullet loan. This is where the full principal is repaid at the end of the loan period. The most common example of this is an interest-only mortgage.