Introduction
When it comes to mortgages and car loans, amortization is a crucial aspect to consider. Amortization refers to the process of gradually paying off a loan through regular payments, which include both principal and interest. There are different types of amortization methods available, but in the real world, the most commonly used types for mortgages and car loans are the constant payment method and the fixed principal method. In this article, we will explore these two types of amortization and discuss their features, benefits, and drawbacks.
Constant Payment Method
Definition: The constant payment method, also known as the fixed installment method, is a type of amortization where the borrower makes equal monthly payments throughout the loan term. These payments consist of both principal and interest, with the interest portion gradually decreasing over time as the principal balance is paid down.
Features: Under the constant payment method, the total monthly payment remains the same, but the proportion of principal and interest changes over time. Initially, a larger portion of the payment goes towards interest, while the remaining amount is applied towards the principal. As the loan progresses, the interest portion decreases, and the principal portion increases.
Benefits: The constant payment method offers predictability and ease of budgeting for borrowers. Since the monthly payment remains constant, borrowers can plan their finances accordingly and know exactly how much they need to allocate towards their loan repayment each month. This method also allows borrowers to build equity in their property or vehicle at a consistent pace.
Drawbacks: One drawback of the constant payment method is that borrowers pay more interest over the life of the loan compared to other amortization methods. This is because the interest is calculated based on the outstanding principal balance, which is higher in the earlier stages of the loan. Additionally, the constant payment method may not be suitable for borrowers who prefer to have lower monthly payments initially, as a larger portion of the payment goes towards interest in the early years.
Fixed Principal Method
Definition: The fixed principal method, also known as the declining balance method, is a type of amortization where the borrower pays a fixed amount towards the principal balance of the loan each month. The interest portion of the payment is calculated based on the outstanding principal balance, resulting in varying total monthly payments over the loan term.
Features: Under the fixed principal method, the principal portion of the payment remains constant, while the interest portion changes over time. As the principal balance decreases, the interest portion also decreases, resulting in lower total monthly payments as the loan progresses.
Benefits: The fixed principal method allows borrowers to pay off their loans faster compared to the constant payment method. Since a fixed amount goes towards the principal balance each month, the outstanding balance decreases at a faster rate. This method is beneficial for borrowers who want to minimize the amount of interest paid over the life of the loan.
Drawbacks: One drawback of the fixed principal method is that the monthly payments can vary, which may make budgeting more challenging for some borrowers. The initial payments are higher compared to the constant payment method, which may be a disadvantage for those who prefer lower monthly payments at the beginning of the loan term.
Conclusion
In the real world, the most commonly used types of amortization for mortgages and car loans are the constant payment method and the fixed principal method. The constant payment method offers predictability and ease of budgeting, while the fixed principal method allows borrowers to pay off their loans faster and minimize the amount of interest paid. Both methods have their own benefits and drawbacks, and the choice between them depends on the borrower’s financial goals and preferences.
References
– Investopedia: www.investopedia.com
– The Balance: www.thebalance.com
– Bankrate: www.bankrate.com
