Amortization

The interest rate is the first thing that every person, who is set on getting a personal loan, checks. But there are other factors, too, which determine the final amount that you pay every month. The most significant one of these is an amortization schedule. Continue reading to know all that you need to know about amortization…

Personal loans are one of the most popular modes of financing in UAE. A personal loan, in basic terms, is an unsecured loan that does not require any guarantor or collateral to avail it. It comes in handy when the borrower has personal needs that are urgent or immediate in nature. Even though personal loans are easily available in UAE, it is extremely important to opt for a loan that offers you the best interest rate and overall buying experience.

Even though everyone checks the interest rate charged, there is some calculation involved that determines the significant amount that needs to be paid monthly. To calculate this, we use the concept of amortization. Amortization is a concept that explains the reduction of a debt over the period by making regular payments. The monthly payments will include both the interest rate amount and the principal amount. Keep in mind that the percentage of the interest amount keeps getting down towards the end of the tenure. 

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What is an amortization schedule?

An amortization schedule is a complete table of periodic loan payments, showing the amount of principal and the amount of interest that comprise each payment until the loan is paid off at the end of its term. While each periodic payment is the same amount early in the schedule, the majority of each payment is what is owed in interest; later in the schedule, the majority of each payment covers the loan’s principal. The last line of the schedule shows the borrower’s total interest and principal payments for the entire loan term.

When does an amortization schedule come to use?

Borrowers and lenders use amortization schedules for installment loans that have payoff dates that are known at the time the loan is taken out, such as a mortgage or a car loan. If you know the term of a loan and the total periodic payment, there is an easy way to calculate an amortization schedule without resorting to the use of an online amortization schedule or calculator. Amortization tables can help a lender keep a track of what they owe and when, as well as forecast the outstanding balance or interest at any point in the cycle. Amortization schedules are often seen when dealing with installment loans that have known payoff dates at the time the loan is taken out, such as a mortgage or a car loan.

What is the formula to calculate the monthly installment?

There is a formula to calculate the monthly installment, that is:

I = P[r(1+r)^n/(((1+r)^n)-1)] 

where,

I = Monthly Installment Amount 

P = Principal Amount

r = Interest Rate (per month)

n = tenure of the loan (in months)

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For example, consider a loan amount of AED 5000 for a tenure of 1 year and an interest rate of 10%(per month) is charged. As per the tenure of 1 year i.e. 12 months and 10% interest rate on loan amount AED 5000. The interest rate levied monthly would be (10%/12) = 0.00833% of the outstanding loan balance. Therefore,

I = 5000[ 0.0083(1+0.0083)^12/ (((1+0.0083)^12)-1)] = 440 

So, the monthly installment would be AED 440, where 0.008% of the outstanding principal amount will be the interest amount and the rest will be reduced from the outstanding principal balance. From the 2nd month onwards,  the percentage of the interest amount in the monthly installment keeps getting decreased, and the percentage of loan amount installment increases. By the end of the 12th month, the loan will be cleared. Towards the end, only AED 4 is the interest amount paid. The total schedule/ table of the monthly payments is called an amortization schedule. 

Special considerations

If a borrower chooses a shorter amortization period for their mortgage – for example, 15 years – they will save considerably on interest over the life of the loan, and own the house sooner. Also, interest rates on shorter-term loans are often at a discount compared with longer-term loans. Short amortization mortgages are good options for borrowers who can handle higher monthly payments without hardship. Remember that it is important to consider whether or not you can maintain that level of payment.

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Note that when the loan holder makes any additional payments other than the monthly installment amount or make a partial payment, it will reduce the share of interest amount in the monthly installment and reduce the tenure of the loan, for sure.