Understanding the basics of Loan Amortisation

You are a salaried individual, planning to take a home loan to be repaid in fixed monthly instalments. You want the debt completely paid off when you pay the last monthly instalment. So, how do you do that? You figure out a fixed monthly repayment amount in a way that it accounts for both the principal amount and the interest and eliminates your debt over a period of time. So, this process of spreading out the loan to create fixed monthly payments is known as loan amortisation.

When you amortise your loan, you agree to pay a fixed amount every month - a portion of that amount goes towards your interest payments and the remaining goes for repayment of the principal amount. Although your total monthly payment will remain fixed, the parts (interest and principal) that make up these payments keep changing over time. During the early months of the loan, your interest charges would be at their highest. In fact, a major part of your monthly payments during the initial months would be your interest expense, and you pay only a small amount for the principal. However, as months go by, the amount that goes towards repayment of principal keeps increasing, while the interest portion keeps reducing.

Types of Amortising Loans

Any loan that requires you to make equal monthly payments and brings your debt down to zero with these payments is an amortised loan. Some common examples of amortised loans include:

  • Auto loans: In Singapore, cars are quite expensive. That’s why, most Singaporeans prefer to take an auto loan. Most often, these loans are paid off through amortisation. This means that you pay an equal amount every month over the tenure of the loan. Also, the interest you pay during the initial months is much higher than the interest you pay towards the end of the loan.
  • Home loans: When you take a home loan, you look at the interest rates and your monthly repayment amount. But do you know how the home loan works and how the monthly repayment amount is calculated? It’s calculated using the amortisation formula, so that when you make your last payment, your debt is paid off completely.
  • Personal loans: Most personal loans are also amortised. Every monthly repayment consists of interest and principal.

An Illustration to Explain How Amortisation Works

Assume that you are borrowing S$50,000 for a period of 12 months with 5% p.a. interest (payable monthly). Based on your fixed monthly repayment amount, which can be calculated using the Amortisation calculator, you can find out how much of your monthly payments is going into interest and how much is going into repaying the principal amount. Take a look at the table to understand how amortisation works.

Month Outstanding Principal (at the start of the month) Monthly Payment Principal Paid Interest Paid Outstanding Principal (at the end of the month)
1 S$50,000 S$4,280.37 S$4,072.02 S$208.35 S$45,927.98
2 S$45,927.98 S$4,280.37 S$4,088.99 S$191.38 S$41,838.99
3 S$41,838.99 S$4,280.37 S$4,106.03 S$174.34 S$37,732.96
4 S$37,732.96 S$4,280.37 S$4,123.14 S$157.23 S$33,609.82
5 S$33,609.82 S$4,280.37 S$4,140.32 S$140.05 S$29,469.50
6 S$29,469.50 S$4,280.37 S$4,157.57 S$122.80 S$25,311.93
7 S$25,311.93 S$4,280.37 S$4,174.90 S$105.47 S$21,137.03
8 S$21,137.03 S$4,280.37 S$4,192.29 S$88.08 S$16,944.74
9 S$16,944.74 S$4,280.37 S$4,209.76 S$70.61 S$12,734.98
10 S$12,734.98 S$4,280.37 S$4,227.30 S$53.07 S$8,507.68
11 S$8,507.68 S$4,280.37 S$4,244.92 S$35.45 S$4,262.76
12 S$4,262.76 S$4,280.37 S$4,262.76 S$17.61 S$0.00

What Are Unamortised Loans?

Unamortised loans require you to pay just the interest amount every month, leaving you with the principal amount to be paid at the end of the loan. These loans work best for the people who prefer lower monthly repayments and who can repay the principal amount in lump sum. Some examples of unamortised loans include credit cards, personal line of credit, and balance transfer.

How Loan Amortisation is Beneficial For You

  • Avoid lump sum payment: Amortised loans are easier to repay as you pay both principal and interest every month, thus avoiding large payments at the end of the loan. Also, as you repay the loan, your ownership in the asset continues to increase.
  • Know the real cost of your loan: Amortisation helps you understand the actual cost of your loan and make the right decision while comparing loans. From the amortisation table, you can quickly add up the interest you will be paying every month to know the total cost of your loan. So, in the above example, the total interest you will be paying over 12 months is S$1,364.44.

Loans are Not Always Amortised

Not all loans are amortised. There are certain types of loans where you pay only the interest, fixed or variable, throughout the tenure while the principal amount is paid back at the end of the tenure in a single payment. Check out some of the most common types of unamortised loans in Singapore:

  • Student loans: With a student loan, there are no repayments as long as you are studying. Although you don’t have to pay the interest before the repayment period begins, the interest may start to accrue during the tenure of the loan, depending on the type of student loan. It usually happens in case of unsubsidised loans where interest starts accruing when the loan period begins. For subsidised loans, interest accrues once the repayment period starts.
  • Interest only loans: These loans are designed to allow you to pay only the interest amount for a certain period, before you start paying your principal amount too. Such loans can be useful if you need funds for investing elsewhere.
  • Credit cards: Borrowing on your credit card can also be considered as an unamortised loan, since you don’t have to pay a fixed amount every month. You can continue to enjoy the benefits of your credit card and borrow as many times as you like, as long as you pay the minimum due amount every month.

Understanding Negative Amortisation

Negative amortisation is a situation when your monthly payments are not enough to cover the interest that is due for the month, leading to a continuing increase in your principal loan amount. It is possible in case of any type of loan and often leads to a difficult situation where your outstanding amount continues to grow every month.Here’s an illustration to help you understand how negative amortisation works.

The situation of negative amortisation usually arises when you are simply not in a position to make the monthly payment. It also happens sometimes when one takes a loan to buy an out-of-budget property hoping to have enough income in the future to repay it.

Partially Amortised Loan

With a partially amortised loan, you pay a part of the principal amount during the tenure of the loan, while the remaining balance is paid at the end of the loan term as a balloon payment. Partially amortised loans could be useful in situations when you can’t afford the monthly payments of a fully amortised loan.Here’s an illustration to help you understand how these loans work.

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