Amortization of loans
People borrow small amounts, generally from friends and relatives, to meet some of their immediate necessities and repay these amounts entirely at one go from their next pay packet. But when the amount required is slightly larger than weekly or monthly pay packets, people start reviewing their anticipated receipts. If some of their deposits are likely to mature in near future, and adequately cover this slightly larger requirement, then taking some short or medium term personal loans from banks is considered.
When the required sum is much larger and there is no way to repay it in its entirety from such anticipated receipts, then people take a long-term loan, which is repayable over a long period of time from future earnings. This method of repaying the loan is known as amortization.
To obtain an amortizable loan, the borrower has to provide security in form of some valuable asset the value whereof is equal if not more than the loan being obtained. Generally people take such large loans for purchasing or refurbishing a valuable asset such as home or commercial property. Though shorter-term amortizable loans are also available, such as vehicle loans. Lenders, therefore stipulate that the asset being acquired with the loan be offered as security or collateral.
Amortizable loans are repayable in regular installments. These installments can be monthly, quarterly, or yearly. Generally, however, loans are amortized on monthly basis. The monthly installments are also equated. Part of this equated monthly installment is the principal and the rest is attributable towards the interest.
The interest on amortizable loans can be calculated either in straight-line method or in reducing balance method. Following examples illustrate the differences between the two methods.
Example 1 (Straight line method)
Mr. A borrows a sum of $5,000 to acquire a car. The loan is repayable over a period of three years, i.e., 36 installments. Interest is calculated at the rate of 10 percent per annum, on straight-line method.
Therefore, the monthly installment that Mr. A. will be paying would be calculated as follows:
Interest component:
5,000 x 10/100 * 3 = 1500
Principal component
5000
Interest plus principal component = 6,500
Divided by 36 months = 180.56 dollars.
Example 2 (Reducing balance method)
Consider the same data for arriving at comparable figures.
Here the interest component is calculated differently.
For this create an Excel sheet with following legends
A1 Month number
B1 Principal
C1 Interest per month at the rate of 10 percent per annum
D1 - Monthly installments
E1 Principal repaid during the month
F1 - Balance principal at the end of the month
Now type the following formulae
A3 = +1
A4 = +A3+1
B3 = +5000
C3 = +B3+10/100/12
D3 = Note that this is a variable that is to be determined
Tentatively type a zero in this cell
E3 = +$D$3 C3
F3 = +B3 E3
B4 = F3
D4 = +D3
Highlight C3 to F3, and drag down to C4 to F4
Now, highlight A4 to F4, and drag these formulae right up to A38 to F38
Now type an amount higher than C3 in cell D3 till cell F38 reaches as close to zero as possible.
The amount at D3 would be 161.35 dollars.
Effectively, the borrower stands to gain if the lender is offering the loan on reducing balance method.
There are some cleverly disguised ploys employed by the lenders, which the borrower must take note of. Lenders, at times take a few installments upfront. This has the effect of reducing the quantum of loan, even though installment is paid as if the full amount was disbursed. Such terms and conditions make the loan expensive.
Advantages of amortizable loans
- Bankers and other financial institutions offer amortizable loans. Therefore, borrower is not at the mercy of friends, and loan sharks.
- Borrower gets to acquire a valuable asset, with the help of borrowed funds. Therefore, amortizable loans increase the buying capacity (affordability) of the borrower.
- The interest paid on the loan is effectively lower than what it appears, considering the inflation factor.
- If the borrower were to set aside a monthly amount for the same investment, at the end of the period, he would still be short of some amounts, which would be attributable towards the inflation. However, amortizable loans enable the borrower to acquire the asset at current value.
- If the principal amount repaid over the period were discounted at inflation rate, the borrower would have paid a far lower price for the asset than its current value.
Disadvantages of amortizable loans
The major disadvantage of amortizable loans is that if the borrower defaults in repaying installments, he is likely to lose the underlying asset.
Economic view of amortizable loans
Amortizable loans are also positive contributors to the economy of a nation. As receipts are anticipated in a systematic manner, they enable the lenders to plan deployment of funds for long periods. Alternatively, if the lenders receive repayments without any predefined manner, then they cannot plan how much they can disburse and how much of funds they would have at any time for lending. This would force them to forego many lucrative opportunities, and make them turn towards risky lending at higher interest rates to earn profits.
Affordability of borrowers increases demands of valuable products and assets such as homes, each of which has associated ancillary industries. Increase in demand for homes augurs well for these ancillary industries as well. In turn, the employees of these ancillary industries also earn higher, which translates into demand for other things.
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