What Is Fully Amortized Financing?
Fully amortized financing is a loan paid back to the lender over a period of time, usually in monthly payments. The word "amortize" means to bring to death slowly. In the case of a fully amortized loan, it means to bring the financing to a close over time. If a loan requires a large principal payment at the end of the life of the loan, usually called a balloon payment, it is not fully amortized financing. All payments are the same amount, or decreasing, all the way to the end of the last financial payment in fully amortized financing.
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Function
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Fully amortized financing or loans are most often used as a payment system for a repayment plan for credit cards or other loans, such as a house or car loan. This type of financing functions so that as the loan progresses, the interest amount decreases and the principal amount increases, but the total payment amount remains the same. The interest is only calculated on the starting amount of the loan, not the total amount.
Considerations
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The fully amortized loan, or financing, is set up so that each payment includes interest and principle. The interest rate is predetermined and agreed upon by both parties, the lender and the recipient of the financing. The principal is the amount actually paid on the balance of the loan. The payment schedule, or term of the financing, is set up so that the last payment pays the balance of the loan. A car loan, for example, might have a fully amortized loan for repayment over the course of three years, where a house loan of the same type might take 30 years to complete.
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Significance
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It's important for the borrower to understand that the division of the early payments of a fully amortized loan largely consist of interest, especially with a very large loan like a home mortgage. As the borrower makes payments over time, the interest decreases and the principal increases. The borrower should understand that it can take some time to build up equity in his home when a mortgage is under fully amortized financing.
Potential
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A great potential to pay off the financing early is possible if the borrower pays extra money on the principal of the fully amortized loan. Most fully amortized financing is set up to allow extra principal payments throughout the life of the loan. However, when agreeing to such a loan, it's important to read the entire loan document to ensure that these extra principal payments are allowable. With every additional principal payment, the balance of the loan reduces. Thus, less interest is owed with the next payment due and the financing can be paid off earlier than originally scheduled.
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