The amortized loan requires regular equal payments during the life of the loan, of sufficient size and number, to pay all interest due on the loan and reduce the amount owed to zero by the loan's maturity date.
Figure A shows a 6-year, $1000 term loan with interest of $90 due each year of it's life. At the end of the sixth year the entire principal (the amount owed) is due in one lump payment along with the final interest payment. In figure B, the same $1,000 loan is fully amortized by making six equal annual payments of $222.92. From the borrower's standpoint, $222.92 once each year is easier to budget than $90 for 5 years and $1,090 in the sixth year.
Furthermore, the amortized loan shown in Figure B actually costs the borrower less than the term loan. The total payments made under the term loan are $90 + $90 + $90 + $90 + $90 + $1,090 = $1,540. Amortizing the same loan requires total payments of 6 X $222.92 = $1,337.52. The difference is due to the fact that under the amortized loan the borrower begins to pay back part of the $1,000 principal with his first payment. In the first year, $90 of the $222.92 payment goes to interest and the remaining $132.92 reduces the principal owed. Thus, the borrower starts the second year owing only $867.08. At 9% interest per year, the interest on $867.08 is $78.04; therefore, when the borrower makes his second payment of $222.92, only $78.04 goes to interest. The remaining $144.88 is applied to reduce the loan balance, and the borrower starts the third year owing $722.20.
Figure 1:2 charts this repayment program.
Notice that as the loan balance is reduced, the interest that must be paid is reduced, thus allowing a larger and larger portion of each successive payment to be used to reduce the loan balance. As a result, the balance owed drops faster as the loan becomes older; that is, matures.
Amortized Loan To Budget Mortgage