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When you work with financial transactions, you will often encounter the term Amortization. It sounds complicated, but amortization is simply the gradual repayment of a debt in over time. Loans can be fully amortized, partially amortized, or negatively amortized. A fully amortized loan has payments that will pay off the entire principal and accumulated interest at the end of the loan's term. A partially amortized loan has payments that will pay off only a portion of the principal and accumulated interest. Many such loans have a large payment called a balloon payment after a set number of years.
In the case of a home loan, which usually runs 30 years, a borrower might have a balloon payment due at the end of the 15th year. You can also have balloon payments due at the end of loan's term. As an example of how amortization works, let's take a look at the example in the worksheet. So we have a $25,000,000 loan, probably not a home loan, at the rate of 4.9%, and it is going to be paid back over a term of 10 years. In the first example, we'll assume the loan is fully amortized, and it will be paid off at the end of the 10 year term.
In the second, that there is a Balloon Payment of $8,000,000 due at the end of the loan's term. When you calculate the monthly payments on the fully amortized loan, you will see that there will be $263,943.49 per month. On the other hand, when you have an $8, 000,000 Balloon Payment at the end of the loan's term, you have a monthly payment of $212,148.24. Now that difference of about $51,000 could make a very big difference for a company in terms of cash flow.
If they borrow the $25,000,000, and need to save every penny to make that investment work, then the $51,000 a month might make a huge difference. Amortization or the repayment of a debt in over time is the key concept behind loans. The borrower gets the use of the capital immediately, while the lender makes interest over the term of the loan. Most loans will be fully amortized, but there are still quite a few that are only partially amortized, and will have an unpaid balance unless the borrower makes a large payment to make up the unpaid amount.
A negatively amortized loan is a loan where the monthly payments do not cover the loans interest for that month. This type of lending is considered predatory and should be avoided.
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