Amortizing loan

Amortization of debt has two major effects:

Credit risk

First and most importantly, it substantially reduces the credit risk of the loan or bond. In a bullet loan (or bullet bond), the bulk of the credit risk is in the repayment of the principal at maturity, at which point the debt must either be paid off in full or rolled over. By paying off the principal over time, this risk is mitigated.

Interest rate risk

A secondary effect is that amortization reduces the duration of the debt, reducing the debt's sensitivity to interest rate risk, as compared to debt with the same maturity and coupon rate. This is because there are smaller payments in the future, so the weighted-average maturity of the cash flows is lower.

The number weighted average of the times of the principal repayments of an amortizing loan is referred to as the weighted-average life (WAL), also called "average life". It's the average time until a dollar of principal is repaid.

In a formula,

${\displaystyle {\text{WAL}}=\sum _{i=1}^{n}{\frac {P_{i}}{P}}t_{i},}$

where:

• ${\displaystyle P}$ is the principal,
• ${\displaystyle P_{i}}$ is the principal repayment in coupon ${\displaystyle i}$, hence
• ${\displaystyle {\frac {P_{i}}{P}}}$ is the fraction of the principal repaid in coupon ${\displaystyle i}$, and
• ${\displaystyle t_{i}}$ is the time from the start to coupon ${\displaystyle i}$.

• Amortization calculator
• Amortization schedule
• Amortization (business)
• Sinking fund
• Weighted-Average Life