Tuesday, April 07, 2020

Loan Amortization Calculation: How Does it Work?


Calculating the amortization schedule of a loan and the amount of the individual installments before signing a loan contract makes it possible to assess the feasibility of the transaction. In fact, the amortization plan includes all the information relating to the methods and timing envisaged by the credit institution for returning the requested amount. The credit market offers different types of repayment plans, each with specific repayment methods.

Let’s see what there is to know about the subject, including all the information needed to calculate the loan repayment plan.

What is the loan repayment plan?

What is the loan repayment plan?

The amortization schedule defines the timing and methods with which the debt will be settled. By mutual agreement with the credit institution, you will be able to establish its duration and the percentage of interest, and consequently know the amount of the individual installments. In this regard, please note that each repayment installment consists of two distinct parts:

– the principal amount: which corresponds exactly to the money lent by the bank;

– the interest rate: relative to the amount of interest applied to the loan.

Depending on the depreciation plan chosen, the composition of the repayment installments may change. Once the contract is signed, you will then be bound to follow the loan repayment terms reported in the amortization schedule. Remember that you can decide the duration of the loan – and therefore the amortization plan – by changing the amount of the installments.

Obviously a shorter amortization plan will force you to pay more expensive installments; on the contrary, a longer repayment plan will provide for lighter installments. The choice of the duration of the repayment plan will depend on your financial situation, understood as the ability to reconcile the payment of the loan installments with all other recurring expenses.

Also remember that another key variable for the amount of the repayment installments will be the type of interest rates, whether fixed or variable. In the first case you will be sure to always pay the same amount for the duration of the contract. In the second case, instead, you will be exposed to the effects of fluctuations in the wholesale market.

The types of amortization schedule

The types of amortization schedule

The credit market provides for different types of amortization plans, but the most used in Italy is the so-called ” French depreciation”. This is a debt extinction program consisting of a first phase in which the installment is mainly composed of the share of interest, which will gradually be reduced, gradually increasing the principal amount.

In the final part of the contract the principal amount will represent most of the installment. Attention: the amount reimbursed each month will always be the same, only the ‘weight’ that the two components – interest share and principal amount – will have on the installment will change. With the French amortization plan, the creditor ensures that interest is repaid first and then the liquidity paid out.

Let’s try to give a concrete example: a loan of 30,000 euros to be repaid in 10 years, with installments every 6 months and an interest rate of 4%. The installments will therefore be 1,560 euros: 31,200 euros (30,000 plus 4% interest) divided by 20 installments (2 installments per year).

The first installment will consist of a six-month interest rate (2%) on the total capital to be repaid: (30,000 / 100) x 2 = 600 euros. All the rest of the installment will be capital share: 1.560 – 600 = 960 euros. The next installment will then be calculated on the residual capital remaining, therefore: 580.80 euros for the interest portion – (29.040 / 100) x 2 – and 979.20 euros for the interest portion (1.560 – 979.80). And so on, until the capital runs out.

What are the other types of amortization plans?

What are the other types of amortization plans?

There are also other types of amortization plans, less frequent on the Italian market:

  • variable rate amortization plan: the capital and interest shares can be redefined each time the rate changes; alternatively, only the interest rate can vary, while the capital share remains based on the original rate;
  • amortization plan in increasing or decreasing installments: the amount of the installments increases or decreases over the years based on a pre-established program;
  • free amortization plan: the interest rate is fixed, while the principal can be returned freely, even if within certain deadlines;
  • plan with fixed installment but variable rate and duration: the installment always corresponds to the same figure, but its composition changes with the interest rate. The duration then becomes variable in turn, until the debt is completely extinguished.

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