Understanding Amortization
Amortization is the process of paying for a loan by making a series of fixed payments each month (or other agreed upon periods) until your balance reaches zero. When you make regular monthly payments on your home, car, motorcycle, or any other financed purchase, you are amortizing the loan.
What do you mean by amortization?
When you obtain a loan to finance an expensive purchase like a house or a car, your lender calculates how much money they will lend to you and for how long based on factors such as your income, the purchase price, and expected interest rate. The rest of the terms will be detailed in your promissory note, which outlines your legal obligations when taking out that loan. One of these terms is how long it should take for them to receive the full amount of the loan back, known as the "amortization period” or “loan term”.
Each month (or other predetermined time period), your lender requires you to make a fixed payment that goes towards both the interest accrued on the outstanding loan balance and the principal itself. This payment is called an amortization payment. As you make these payments, you gradually reduce your principal balance.
What affects amortization?
The size of your amortization payments each month depend on a number of factors, including:
- The purchase price of whatever you're buying
- The interest rate on your loan
- The length of your loan term
- Any additional fees or penalties associated with the loan
- Whether you make extra payments or not
It's important to be aware that even if your interest rate is low, your amortization period can make the total cost of your loan larger than you realize. For example, on a 5-year mortgage of PHP 1,853,600.00 at 9.346% interest, your total loan cost will be PHP 2,327,400.00. This means that over the course of 60 monthly payments across 5 years, you'll pay PHP 1,853,600.00 on the principal balance, and another PHP 473,800.00 towards accrued interest.
This is why it's so important to shop around for the lowest interest rate when taking out a large loan. The higher the interest rate, the more you spend on interest on top of the principal amount you borrow.
This is why it’s important to gauge how long you intend to pay your loan. You may have to pay less in monthly amortizations if you have a long payment term. However, it might also mean a higher interest rate. On the other hand, if you opt for a short payment term, you may pay more on a monthly basis, but you pay less in terms of interest overall.
What else should I consider when taking out a large loan?
When looking into ways to finance major purchases such as homes and cars, there are several things you should consider before signing any contracts:
- Amortization payments
- How much money is needed for a down payment
- Monthly fees/pricing/etc. for whatever you want to purchase
- Payment options or amortization period
It's important to consider all of these details before taking on a large loan because there are several different financing options available. Some may have lower interest rates but require bigger down payments,while others offer low monthly fees and flexible payment plans. Some might charge higher monthly fees but entitle you to tax deductions depending on what you purchased. These are just a few examples of the many ways you can compare different loans so that you ultimately get one that is most financially beneficial for your specific situation.
What's the relationship between amortization and depreciation?
Depreciation is when the value of an asset decreases over time. For example, if you bought a car for PHP 2,317,000.00 and three years later it's only worth PHP 1,737,750.00, the car has depreciated by PHP 579,250.00.
Having a good understanding of these two terms is important when taking out a loan, as lenders may use depreciation as a basis for setting a high interest rate on a loan. This is because in some cases the lender may feel that since the asset being financed loses value, there is a greater risk for them if the borrower defaults on the loan.
Going back to the earlier example, let’s say you take out a loan from a bank to purchase a car worth PHP 2,317,000.00. After three years, you are unable to pay your amortizations for several months, so your lender repossesses the car and sells it to recover their loss. However, if the car has depreciated to PHP 1,737,750.00, your lender loses PHP 579,250.00. Your lender might set a high interest rate so that they can minimize their losses should this scenario happen.
In instances like this where the loaned item has a high depreciation rate, it’s better for you to take out a loan with a shorter payment period. With a shorter payment period, you’ll be paying for less interest on your loaned item. If you opt for longer payment periods on items that easily depreciate (like a car or motorcycle), you will find that you will be paying more for the interest than the actual cost of the loaned item. It also makes it more difficult for you to sell the item (should you choose to) before it has used up its useful life.
Amortization does not need to be scary. In fact, with amortization, you are able to buy things you need or want much sooner, such as your dream home or car.
Metrobank offers competitive rates for all consumer loan products. Talk to us today to learn more about a Home Loan and Car Loan.
If you need help computing for your amortization, we’ve made it easier than ever with the Metrobank housing loan amortization calculatorand Metrobank car loan amortization calculator.
