What is Amortization in Commercial Real Estate?
Amortization is the process of spreading a loan into payments that consist of both principal and interest over a set timeline, called an amortization schedule. While some commercial real estate loans are fully amortizing, not all are. For example, balloon loans are typically only partially amortizing, while interest-only loans (like many commercial construction loans) usually have a non-amortizing interest-only period, then a period that is either partially or fully amortizing.
Principal and Interest in Amortized Loans
In an amortized loan, as a borrower pays off their principal, the amount of interest they have to pay decreases. This is because the amount of interest charged is based upon the most recent principal balance of the loan. As a borrower continues to pay off their loan, the proportion of the payment that goes to interest decreases, while the proportion that goes to paying off the principal increases.
Balloon Loans in Commercial Real Estate
While most real estate loans residential loans are fully amortizing, most commercial real estate loans are not. For example, a loan might have a term of 7 years and an amortization period of 30. That means that, while the borrower will make payments as if the loan was due in 30 years (over a 30 year amortization schedule), the full principal balance of the loan will be due in 7 years. In many cases, commercial real estate borrowers decide to refinance the loan at this point instead of making a large balloon payment.
Negatively Amortizing Loans Can Be Particularly Risky For Borrowers
In some cases, loans may be negatively amortizing, meaning that a borrower isn't even fully paying the interest on the loan. Negatively amortizing loans can be particularly risky for borrowers, since each time a borrower doesn't fully pay off a month's interest, that interest gets added to the principal of the loan. The next month, the borrower will be required to make a larger interest payment on the new, increased principal. In this case, compound interest is actually working against them, and this can become extremely expensive in the long run.