Amortization

Amortization: The schedule over which a loan's principal is actually repaid. It is not necessarily the same as the term, and the gap between the two is where balloon payments live.

Term and amortization are different things

Term is how long the loan agreement lasts. Amortization is the schedule the payment is calculated on. When they match, the loan pays itself off. When amortization is longer than the term, a balance survives the term and falls due as a balloon.

A 5-year term with a 25-year amortization is a 25-year payment with a 5-year deadline.

Why the length changes everything

Lengthening amortization lowers the payment and raises your coverage ratio, which is why it is the standard fix for a deal that does not quite work. It also increases total interest, sometimes dramatically.

• Early payments are mostly interest. On a long amortization the balance barely moves in the first years, which matters if you plan to sell or refinance.
• Equity builds slowly. On real estate this affects what you can borrow against later.
• Never amortize past the asset's useful life. A seven-year loan on a four-year vehicle means paying for something you no longer own.

What to ask before you sign

• What is the term, and what is the amortization? Are they the same?
• What is the total interest over the full schedule?
• Can I pay extra against principal, and is there a prepayment penalty?
• How is extra payment applied — to principal, or to the next scheduled payment?