Loan term and amortization
A loan can be a long-term commitment, with most loan contracts running for years (like a vehicle) or decades (like a mortgage). The loan term and amortization period can help you understand whether you can afford the loan now and how it will impact your finances in the future. Having a good grasp of the loan term and amortization period can also help you consider factors like interest rates, repayment periods, fees, and potential penalty charges.
The difference between term and amortization
The loan term describes the length of time the lender is bound by the terms and conditions of the loan agreement, while the amortization period refers to the total length of time it will take you to pay off the loan.
For example, a mortgage can have a loan term of 5 years and an amortization of 20 years. This means that all terms and conditions, including interest rate and payment amount, are agreed upon for 5 years, but the amount of your payment is based on you paying off the loan in 20 years.
When the amortization period and loan term are equal
If you have a five-year loan amortized over five years, the loan term and amortization periods are equal. In this case, the lender expects repayment of the entire debt, including any associated fees, by the end of the five-year period. If all payments are made on time, the loan would be repaid in five years.
When the amortization period is longer than the loan term
If the loan is financed over a five-year term but amortized over eight years, the amortization period exceeds the loan term. In this scenario, the initial loan contract is only valid for the first five years. After five years, the lender and borrower must renegotiate the loan terms and conditions, including interest rates and monthly payments. When you renegotiate, the new loan terms may have a higher interest rate than the initial loan term, making your new payment higher than the original payment amount and increasing the total value of the loan.
If a borrower owes more on a loan than an asset is worth, this is called negative equity.
Sam needs a new car. He visits the local dealership and figures out that payments on a five-year term/eight-year amortization period loan fit within his budget. After five years of driving the car, the car’s value may reduce significantly. When the loan is renegotiated, the lender takes on more risk because the loan is not secure, meaning the car is worth less than the loan amount.
To lessen their risk, the lender may raise the interest rate on the loan, causing payments to be greater than you can afford. In the car example, the dealer may entice you to trade in your vehicle by offering lower interest rates and lower payments if you buy a new car. They may also offer to lump the remaining amount of your original loan into the loan amount of the new car. In this situation, the new loan amount is greater than what the new car is worth, causing you to have negative equity.
Loan and credit agreements
In addition to loan term and amortization period, there are some common words you will find in most loan contracts, like repayment period, interest rate, fees, penalty, default charges. Visit Understanding Credit Agreements to learn more about what to look for in a loan or credit agreement.