Amortized and unamortized debt can both used for home, vehicle and commercial loans. Both types of debt are secured by the underlying asset. If the borrower stops making payments, the lender has the right to foreclose and take it back. With amortized debt, the borrower makes monthly payments consisting of principal and interest. However, with unamortized debt, the borrower pays only the interest.
The primary difference between amortized and unamortized debt is the mix of principal and interest that the borrower is required to pay back monthly. While borrowers pay back principal and interest on amortized debt in their monthly payment schedule, unamortized debt only requires them to pay on their interest.
Amortized Debt Basics
With amortized debt, the borrower makes scheduled principal and interest payments over the life of the loan. An amortization schedule breaks down how much of the borrower’s payment is applied to the principal balance and to the interest. The interest is computed on the initial loan amount.
When the borrower makes a payment, the interest is paid off first and the principal second. This is why most of the payment goes to paying off the interest instead of the principal for the first five or ten years of the loan.
Amortized Debt Pros and Cons
The primary advantage of amortized debt is that with each payment, the borrower builds equity in the asset. After the final payment, the borrower owns the asset. If the loan has a fixed interest rate, the borrower’s payment amount never varies.
The main disadvantage is that the monthly payments can be high since both principal and interest are paid. If the amortized debt has a high interest rate and interest rates drop, the borrower is stuck with an excessively high rate.
Unamortized Debt Basics
Unamortized debt is better known as interest-only debt. The borrower makes monthly payments that consist only of short-term accrued interest. No portion of the loan principal is ever repaid. The full loan amount is paid back at the end of the loan with one balloon payment.
Unamortized debt can have a fixed or adjustable interest rate. With an adjustable rate, the lender can increase the interest rate according to the loan’s terms.
Unamortized Debt Pros and Cons
The primary benefit of unamortized debt is the lower monthly payment. By only paying the interest, the monthly payment can be significantly reduced compared to an amortized loan payment. The main disadvantage is that the borrower never builds up equity in the asset.
The borrower owes the same amount of principal that was originally borrowed. If he can’t pay off the loan’s balloon payment, he must either refinance or lose the asset. If he sells the asset for less than the loan amount, he is responsible for paying the lender the difference.
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