Amortization Explained

“Amortization” in the context of a small business loan refers to the repayment of a loan according to a fixed (or evenly distributed) repayment schedule over a specific period of time. The repayment schedule consists of payments in a fixed amount, while the ratio of principal and interest changes throughout the repayment period. Initially, a greater portion of the payment will be applied to interest, with a smaller portion of the payment applying toward principal. As repayment progresses over time, the inverse would happen — a greater portion would then apply to principal and a smaller portion applying to interest.

For example, under a hypothetical amortization schedule, you would have a fixed repayment amount of $1,000 a month. Initially, $700 would be applied towards interest and $300 would be applied towards principal. Towards the end of the repayment term, however, $900 would be applied to principal and $100 would be applied to interest.

Now let’s dig a little deeper and see how amortization works with more set criteria. Imagine that as a small business owner, you have just been approved for a $100,000 loan at a fixed interest rate of 6%, with a repayment term of 24 months (or 2 years) semi-monthly. How would your amortization schedule look in this scenario?

Your semi-monthly payments would be approximately $2,200. This amount would generally not change throughout the repayment term. The principal and interest ratio, however, would change with every payment. For illustrative purposes, this is how every 10th payment would approximately look:

Payment 1: $2,200 total payment ($1,950 to principal and $250 to interest);

Payment 10: $2,200 total payment ($2,000 to principal and $200 to interest);

Payment 20: $2,200 total payment ($2,050 to principal and $150 to interest);

Payment 30: $2,200 total payment ($2,100 to principal and $100 to interest);

Payment 40: $2,200 total payment ($2,150 to principal and $50 to interest);

And so on…

Benefits of Amortization

Amortization provides small businesses an advantage of having a clear set payment amount every time that includes both interest and principal. An amortized loan allows for the principal to be spread out with the interest, providing a more manageable repayment schedule.  An unamortized loan, on the other hand, would include interest-only payments and a balloon payment at the end for the unpaid principal.

Drawbacks of Amortization

The main drawback of amortization is that the borrower sometimes does not realize how much he/she is actually paying in interest. It is important to determine the total amount of interest paid and not just look at what the fixed repayment amount is.

In addition, it is important to make sure that the payments cover any interest that accrues. Generally, any payments under an amortization schedule should be proportioned adequately to cover any interest that accrues. In the event that the interest-portion of the payment does not cover the interest that accrues, negative amortization occurs. Negative amortization causes the balance of the loan to increase. Interest capitalization (which often occurs after a period of deferment or forbearance) is a form of negative amortization.

See your customized amortization schedule here with Bankrate’s free business loan calculator.

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