Loan Amortization
Loan amortization is usually calculated at the time of signing the mortgage loan contract. As mentioned above loan amortization is the process of accounting for each individual payment throughout the life of the loan. Loan amortization process is different from repayment models installments that are composed of both principal and interest. The loan amortization process is essentially used in loan repayment and sinking funds. Loan amortization simplifies the process of loan repayment the payments by dividing the total loan amount into equal installments spread over the life of the loan. Additional money is added to the principal amount at the end of the mortgage term whereas a greater amount of payment is applicable to interest at commencement of monthly installments. The concept of amortization in accounting refers to disbursement of acquisition cost less residual value of the intangible assets (such as patents, trademarks, and copy rights) in an orderly manner over the time period in which they are used. This would clarify use, expiration, obsolescence and other decreases in value resulting from both usage and other sources. The counterpart of amortization for tangible assets is depreciation. The process is fundamentally the same i.e. we depreciate the total value of the asset over its useful life. There are two methods of depreciation i.e. straight line depreciation method and double declining depreciation method. A common problem faced by accountants when using the amortization concept is that many intangible assets (such as goodwill, brand names, trademarks etc) may have indefinite life. Consequently these assets cannot be amortized. Treatment of amortization in financial statements of a company is such that as value of the intangible asset is decreased over its useful life.
The process of paying a loan through specially structured periodic payments is amortization. Amortized loans are different from other loans in that their payments are structured in a different manner. Mortgage payments are a simple form of amortized loans. In case of the home mortgage loans monthly payments and interest rate remain fixed throughout the life of the mortgage loan. However the last payment may be substantially different from monthly payments in most mortgage loans. Amortized payments are computed by dividing the principal amount (i.e. balance of the total loaned amount after deducting down payment). Each amortized payment comprises of a certain percentage of interest and also a portion of the principal amount. Some people tend to confuse the concept of loan amortization with interest only loans. With an amortized loan a larger chunk of monthly payments are diverted to interest initially. However a portion of principal is paid in this period as well. On the contrary in case of interest only loans the entire amount of interest is paid off before paying any part of the principal i.e. principal payment resumes only after interest has been fully paid. Interest only loans are advantageous for short term investors but are not suitable for home mortgages. It may take up to or more than half the life of the loan for interest and principal amounts to become equal in an amortized loan structure. By reducing the interest balance by making more frequent payments ultimately triggers off the principal payment.
Negative amortization a seemingly complex term is defined as the reduction of credit by continuous payments of interest and principle amounts. Negative amortization occurs as an outcome of mortgage repayment plan that allows borrowers to make monthly payments smaller than the amount of monthly interest payable. The entire loan balance will be increased as a result of difference in more interest piling up on top of the previous interest due to the mortgage loan company. Negative amortization loans have many other names including option arms, leg arms, flex saver and power option etc. If borrowers are allowed to make smaller payment in one month the distinctive payment in the next month will obviously be larger. Negative amortization loans were initiated to be used as the elastic payment option. This option was very useful for borrowers who had to wait for long period to get paid for example monthly payments on home construction loans are started only after the construction is completed. After finishing huge projects that may have run out of money many borrowers may not be a position to furnish full payment in the preceding month. Negative amortization loans are a feasible option for such individuals and institutions. Instead of clarification of negative effects and complications of negative amortization loans lenders and banks advertise neg arm loans as the payment mortgage. This would result in a massive increase in people who default on their loans leading to bankruptcy and foreclosure. Make sure you clearly understand how negative amortization works and whether it matches your specific requirements before opting for negative amortization.
Traditionally the most common reason for undertaking negative amortization was to make reduce monthly mortgage payments in the initial period of the mortgage loan. This feature of negative amortization loans was used for both fixed rate mortgage loans and adjustable rate mortgage loans. Another reason for using negative amortization for adjustable rate mortgage loans is to reduce the size of the probable payment shock. Negative amortization also has some disadvantages including that payments are increased after the as you still have to pay both interest and principal. The increase in monthly mortgage payments may be rather big because they are required to completely amortize the loan in the same payback period. In times of increasing interest rates negative amortization on variable rate mortgages can be used for the same purpose i.e. reducing interest payments in early years of the mortgage loan. Payments in early years are intentionally set low as compared to interest due to lender giving rise to negative amortization. As mentioned above you can check your loan amortization and negative loan amortization schedules by entering your primary information in a loan amortization calculator. The usefulness of both loan amortization and negative loan amortization varies from person to person and you should make a decision by carefully examining how it fulfills your needs.