When it comes to mortgages, there are two main ways payments can be structured: amortized and interest-only. Both borrowing structures have advantages and disadvantages, so it’s essential to understand each before committing to a loan. Here’s a look at the differences between amortized vs. interest-only payments.
What Is an Amortized Loan?
An amortized loan is a type of financing where monthly payments apply to both the principal balance of the loan and the interest. Over time, more of each payment goes toward paying down the principal balance and less toward interest. This payment type is also called a level payment if it’s a fixed-rate loan.
An amortized loan payment schedule lists the total loan amount, the amount of each monthly payment, the interest rate, and the number of months in the loan. Amortization schedules also show how much of each payment counts against the principal balance and how much goes toward interest.
The advantage of an amortized payment is that it helps you pay off your loan faster—and save money on interest in the long run. On the other hand, this means that your monthly payments are higher than they would be with an interest-only payment.
Amortized Loan Example
Consider a $100,000 loan that is amortized over 30 years at an interest rate of 5%. In this case, the monthly payment is $536.82. Of that amount, $120.15 goes toward the principal balance in the first month, and $416.67 goes toward interest. Over the life of the loan, however, an increasing portion of the monthly payments will go toward principal, with less going toward interest expense.
Over the life of the loan, the borrower pays a total of $93,256 in interest—almost as much as the total loan amount.
What Is an Interest-Only Loan?
With interest-only payments, the monthly payment only applies to the interest on your loan. Your payment does not pay down the loan’s principal balance unless you pay more than the minimum interest required each month.
Because you only pay the interest on the loan each month, your monthly payment is lower than it would be with an amortized payment. Still, you will not make any progress towards paying off the loan principal.
Interest-Only Loan Example
Based on the same 30-year loan for $100,000 at an interest rate of 5%, the monthly payment would be $416.67 (lower than the amortized payment of $536.82). However, in this case, the entire amount goes toward the interest—the balance does not decline over time unless you make extra payments.
In this example, the borrower pays $150,000 in interest (more than the total loan amount) and still owes the lender $100,000 when they get to the end of their loan term if they did not make any additional payments.
Fully Amortized vs. Interest-Only Payments
The best type of mortgage payment depends on your financial goals and objectives. If you’re looking to pay off your loan as quickly as possible—and save money on interest in the long run—then an amortized payment is the way to go. An interest-only payment may be better if you prefer to keep your monthly payments low.
Keep in mind that with an interest-only payment, you’re not making any progress towards paying off the principal balance of your loan. When the loan period ends, you will still owe the entire amount of the loan plus any accumulated interest.
If you’re unsure which type of payment is right for you, speak with a financial advisor or mortgage specialist. They can help you understand your options and make the best decision for your unique situation.
Interest-Only Loan Pros and Cons
Interest-Only Pros
- Smaller monthly payments. One of the most significant benefits of interest-only mortgages is that monthly payments are more affordable, especially in the early years of a loan when the majority of payments go toward interest.
- Increased cash flow. With an interest-only payment, you don’t pay down the loan principal. That translates into more available cash each month, which can be helpful if you’re trying to save up for a down payment on another property or invest in other areas.
- Deferred principal payments. With an interest-only loan, you can choose to defer your principal payments for a certain period. This approach can be helpful if you’re expecting a large influx of cash (such as a bonus or inheritance) you can use to pay down the loan principal all at once.
- Larger profit margins. If you’re using your loan for investment purposes, an interest-only payment can increase your profit margins. More of your income can go towards other expenses or investments rather than mortgage payments.
- More cash to cover expenses. An interest-only payment can also give you more money to cover repairs, renovations, or other unexpected expenses.
Interest-Only Cons
- Doesn’t build up equity in the property. With interest-only loans, you don’t build any equity in the property while making monthly payments. This can be a problem if you need to sell or refinance before the loan period ends.
- Balloon payment at the end of the loan term. Because you’re not paying down the loan principal, the entire loan amount is due at the end of the loan term. This can be a problem if you don’t have enough money to pay the loan in full.
- Increased monthly payment after the interest-only period ends. Once the interest-only period of your loan ends, monthly payments can increase because you’ll begin to pay down the principal balance plus interest.
- Higher probability of default. Interest-only loans tend to have smaller monthly payments, so there’s a higher probability that borrowers will default on their loans.
Frequently Asked Questions
Is an amortized loan better?
Amortized loans are better because they allow borrowers to slowly pay off the principal balance of a loan over time. This can be helpful when budgeting for monthly mortgage payments. It also means the borrower won’t face a large balloon payment at the end of the loan term.
Can you pay off an amortized loan early?
You can usually pay off an amortized loan early by making a lump sum payment or refinancing the loan. However, there may be penalties associated with early repayment, so speak with your lender to understand the terms of your loan agreement.
What happens when you pay extra on an amortized loan?
When you make an extra payment on an amortized loan, the money applies toward the loan’s principal balance. This can reduce the amount of time it takes to pay off the loan and can reduce interest costs over the life of the loan.
