Commercial loans are available in a variety of different arrangements designed to fit the borrower’s needs. Here we will discuss the some of the more common loan amortization structures. Each has it’s advantages and disadvantages. Careful planning should be exercised by the borrower to insure the loan terms he gets can be paid as agreed.
With regard to interest rate there are two basic types of mortgage loans available. The first is a fixed interest rate whose interest rate does not change over the life of the loan. This results in equal monthly payments throughout the life of the loan. The other type is an adjustable rate mortgage whose interest rate can change periodically. The adjustments will typically take place at 1, 3, or 5 year intervals. The interest rate on an adjustable rate mortgage will usually start out lower than the interest rate of a comparable fixed rate mortgage. The lower initial monthly payments are often enticing to the borrower. Fixed rate mortgages are fairly common in residential lending but are rarely seen in commercial lending.
Fully amortizing loans are loans whose entire balance is paid in full at the end of the loan term. All monthly payments are typically equal. The interest portion of the monthly payment will be “front end loaded” so that the payment is largely interest in the early years. In later years the interest portion declines and the principal portion of the payment increases. With a partial loan amortization, the loan will be structured so that when the loan comes due there will be a remaining balance. It is common for the loan to become due in 5 or maybe 10 years. The monthly payment amount will be calculated as though the loan were going to last 20, 25, or 30 years. If the loan comes due in 5 years the entire balance must be paid off or refinanced. Banks will typically refinance their own loan after it comes due as long as the borrower has met all his obligations. This refinance will generally be done at prevailing market interest rates. A loan that is amortized over 20 years but comes due in 5 years is sometimes called a “20 due in 5”. This is the most common arrangement utilized by banks today.
Interest only loans are loans whose monthly payment is totally interest and no part of the payment is applied to the principal. The advantage of the interest only payment is that it is much smaller than a fully amortizing loan. The disadvantage is that when the loan comes due the original principal balance will still be due. Examples of interest only loans are home equity lines of credit and bridge loans. Home equity loans are a form of second mortgage often used to provide the borrower with a quick source of cash. A bridge loan is short term loan made to expedite the borrowing process. Refinancing will be required at the due date.
A negatively amortized loan has an even lower payment that an interest only loan. With negative loan amortization the monthly payment is set at a point where the principal portion of the payment is smaller than the principal portion of a fully amortizing loan. This monthly shortfall in the principal payment results in the principal balance increasing with time. You can literally make payments for a period of time and owe more than the original principal borrowed. The low monthly payment can be helpful in the beginning but the borrower must plan for increasing payments later.
With straight line amortization the principal payment remains constant over the life of the loan. The interest portion of the monthly payment is based on the remaining balance of the loan. Clearly the interest portion is much larger in the beginning. This results in higher payments in the early years. The conventional mortgage amortization results in equal and predictable payments. The interest portion is still dependent on the remaining balance. The principal reduction is lower in the early years. The advantage of the straight line method is that larger principal payments are being made in the beginning. This may suit a borrower who wants to pay his debt down sooner. The advantage of the conventional amortization is that the payments are fixed during the period.