Definition: An amortized bond is a type of secured financing where the loan principal is paid in full at the end of the term, with any interest earned over that time being applied to the loan’s remaining balance. Interest is charged on the unpaid principal plus any late fees and penalties which may be incurred in removing, replacing, or altering the property. If you pay off your principal before the end of your term, you get a zero-percent return on your investment.
Like mortgage bonds, amortized bonds mature after a set period, typically 30 years, and are sold to individuals or institutions at a discounted price. Unlike mortgage bonds, though, they are not purchased with money borrowed from banks; rather, they are bought by investors who may or may not have access to regular debt financing.
However, unlike a regular loan, an amortized bond payments are not spread out over time like other loans. Instead, payments on an amortized bond are made equally on each payment due as they are in full right from the beginning; therefore, if you are making monthly payments on your loan principal.
The benefits of amortized bonds are
1. They assist in reducing debt over time.
2. They allow for a gradual decrease in interest rates.
3. They capitalize newly earned interest income, reducing its duration, thus achieving both principal and interest savings.
Amortization bonds are generally considered safe investments; therefore, there is less focus on their perceived risk factors.
Types of Amortized Bonds
- The straight-line method of amortization for debt is used when debt is not payable in full at maturity, and the payment schedule reflects payment in equal monthly installments over the life of the debt. This form of amortization can be used when payment is expected to be evenly spread over the life of the loan. Payments will be scheduled at intervals that produce a profit and capitalize the interest. Therefore, payments made at the start of each month and the end of each month will be discounted at the amortized price for the month in which they are made.
- The effective interest method uses an adjusted schedule of interest charges instead of a fixed amount each month for a fixed term. This gives more flexibility in managing your debt as your income changes, and it reduces the impact of higher interest periods that can occur when you pay bills late or don’t pay them at all.
Amortized bonds are commonly held by investors who want income during key events in their lives, such as buying a house or car. Because the price paid for the bond diminishes with time rather than being fully paid at the time of payment, investors use the term ‘amortized’ to describe the approach investors take when buying and selling such bonds. Investors generally purchase amortized bonds when prices are low and assume that they will receive more cash than they paid for them when they bought them, although this assumption can be wrong.