the way you repay your loan can make a big difference in the total amount of interest you pay and the amount you pay each month. we'll compare the differences between amortization, balloon payments, and equalized payments, plus tips on how to reduce your total interest, budgeting tips, and the advantages of each.
when borrowing money, it's easy to focus on the interest rate and overlook the differences in loan repaymentoptions. I didn't realize this when I took out my first loan, and it wasn't until later that I realized that the repayment option can make a big difference in your monthly payment and total interest burden. Today, we'll compare the three most common loan repayment options - amortization, equalization, and principal amortization - and figure out which one is best for your situation.
prepayment
with anamortizingloan, you make monthly interest-only payments over the life of the loan, and then pay off the principal in one lump sum on the maturity date. This has the advantage of lower monthly payments,especially if you know you'll have money coming in before the loan matures.
however, if you don't pay off the principal until maturity, you'll end up with the highest total interest cost, and banks charge higher interest rates because of the risk of repossession. there's also the pressure of paying off a large sum of money at maturity.
amortization
with anamortizedloan, you pay the same amount of principal (loan principal ÷ number of months) each month, and interest is only calculated on the remaining principal. Your monthly payment is highest at the beginning of the loan, but over time, the principal balance decreases, so the total amount you pay each month gradually decreases.
you'll end up paying the least amount of interest, but the large initial payment can be a burden if you don't have a lot of money to spare. Still, it's the repayment plan that pays the least amount of interest, soif you're looking to reduce your interest costs over the life of your loan, it's a good option. For tips on reducing your total interest, check out our article on reducing the total interest on your loan.
amortizing the principal
withan amortized loan, you pay the same amount of principal (principal + interest)each month. Your bank will calculate the same payment each month by combining the principal and interest, so your monthly payment is consistent. this is great for budgeting because you're paying the same amount each month, and it also has the advantage of having a lower upfront costcompared to equalization.
however, the total interest cost is higher than the equalized repayment. you'll pay off the loan more slowly than you would with an amortizing loan, so you'll pay more in interest.
which loan repayment plan is right for me?
there are distinct advantages and disadvantages to each option, so here are our recommendations based on your situation:
amortization: If you can't afford to pay off the principal each month right away, amortization is a great option. You'll only pay interest for the life of the loan, which can greatly reduce your initial burden, especially if you're expecting a paycheck soon, as you'll be able to tide you over until then.
amortize theprincipal: If you want to save the most money on interest, amortizing the principal is a great option. You'll have a larger upfront payment, but you'll pay the least total interest in theend. For tips on reducing total interest on your loan, check out our article on reducing total interest on loans.
amortization: If you want to pay the same amount each month and stay on budget, amortization is a good option. It's easier on your wallet because the upfront payment is lower than amortization. however, you'll pay more in total interest than with an amortized loan.
it's important to note that whether you're paying off a mortgage or acredit card, you'll end up paying one of these three ways. your loan product will dictate your options, so be sure to check your contract to see which repayment method applies.
frequently asked questions (FAQs)
Q. which repayment plan pays the least amount of interest?
A. The lowest interest repayment plan is the equalized principal repayment plan, which means you pay down more of your principal each month, so you'll pay less interest over the life of the loan than with other plans.
Q. when is it beneficial to pay off my loan at maturity?
A. Consider balloon payments if your loan term is short or if you plan to have a cash infusion near maturity. If you can't afford to make monthly payments right away, you can buy yourself some time with interest-only payments, but be aware that you'll have to pay off the principal in one lump sum at maturity.
Q. can I change my payment plan in the middle of my loan repayment?
A. It's generally not possible to change your repayment plan midway through a loan - you'll need to stick to the plan you decided on when you signed up. If you want to change your plan, you'll need to talk to your lender and consider a refinancing (switching) loan.
Q. should I choose an amortized loan or an equalized loan?
A. It depends on your situation, as there are pros and cons to both options. If you want to pay less interest, you should choose amortization, and ifyou want to pay the same amount each month, you should choose principal equalization.
in conclusion, each loan repayment plan has its own pros and cons, so it's important to choose one that fits your financial situation and goals. Let us know in the comments if you found this article helpful, and subscribe to our newsletter for more financial tips!