You might have heard the term amortization and wondered what it means. Put simply, amortization is how a home loan is paid down. The debt is reduced slowly at the beginning and then more rapidly toward the end.
When the loan is first originated, each mortgage payment goes toward interest. In later years, most of the payment reduces debt. The gradual shift from paying mostly interest to mostly debt payment defines an amortized mortgage.
Before we dive into the nuances of amortization, let’s define a couple more key terms:
Principal: This is the amount of money owed to a mortgage lender. As you make payments, the amount of principal goes down. When it reaches zero, the loan is paid in full.
Interest: This is the fee you pay to a lender for allowing you to borrow their money.
How Does Amortization Work?
Most people aren’t comfortable running the numbers in their heads or on a piece of scrap paper. Instead, they might look to a mortgage amortization calculator to help them develop a plan of attack to pay down the balance. Using such a tool you can:
- Find out how much total interest you would pay over the term of the loan.
- Determine the remaining loan balance at any point in time.
- Figure out how much of each month's payment goes toward principal (debt reduction) and interest.
- Compare the total cost of a 30-year loan versus a mortgage with a shorter term.
- Know when you're approaching 20% equity, so you can cancel private mortgage insurance.
There are a few things it helps to understand when tackling such an endeavor. First, usually, the majority of each payment at the beginning of the loan term pays for interest and a smaller amount pays down the principal balance. With a track record of regular payments, more of each following payment pays down your principal. This reduction of debt over time is called amortization.
Every amortization table will look different, as the mortgage loan principal and interest rate will differ. You can find templates online to create your own amortization spreadsheet. You can also ask your lender for a template.
Once you have this information, you can:
- Set a budget for buying a home
- Play around and see how different down-payment amounts affect your payment and the long-term cost of your loan
- See how much you can save by shopping for the best mortgage rate
- Explore how extra payments might save you money on interest and help you repay your loan faster
When it’s time to create the table, be prepared to supply a few key figures: the amount you borrow for your mortgage, the interest rate, and the term length to get accurate numbers. The idea is that seeing the details of your payments right before your eyes will help you have a better handle on your money and make better decisions about your mortgage and finances.
Also, don't assume all loan details are included in a standard amortization schedule. Some amortization tables show additional details about a loan, including fees such as closing costs and cumulative interest. Be sure to clarify with your lender if they supplied the schedule.
You might be surprised to learn that amortization helps both borrowers and lenders. That’s because borrowers usually want to pay off their loans as soon as possible. Lenders, on the other hand, make money by charging interest on loans. They are often more interested in receiving interest payments than in getting their investment back.
With amortization, by definition, there is a specific period for the borrower to make payments. This allows the payments to remain within the borrower’s financial means and guarantees interest income for the lender.
Amortization and extra payments
You’re likely wondering how to pay off your mortgage faster. It all comes down to simple math. That’s because when you make an extra payment or a payment that's larger than the required payment, you can designate that the extra funds be applied to the principal. Because interest is calculated based on the principal balance, paying down the principal in less time on a fixed-rate loan reduces the amount of interest. Even small additional principal payments can help in this way.
Another way to pay off the loan in a timelier fashion is to make half-monthly payments every 2 weeks, instead of 1 full monthly payment. When you split your payments like this, you’re making the equivalent of 1 extra monthly payment a year (26 bi-weekly payments totals 13 monthly payments). This extra payment may be applied directly to your principal balance. Be sure to confirm with your lender that this option is on the table.
Amortization and Refinancing
A loan amortization schedule can also be insightful when trying to decide if a refinance is right for you. This table lays out how a shorter- or longer-term refinance can affect your overall payment amounts. It can also help you understand the potential tradeoffs involved with refinancing.
While the changes in monthly payments may not seem like they carry a lot of weight at first, an amortization table predicts your total savings for the duration of your loan. This is the best way to get a big-picture understanding of the potential savings and determine if refinancing is the way to go.
Amortization and Other Types of Loans
It’s important to mention that not all loans amortize like this. For example, if you take out an interest-only mortgage loan, you wouldn’t repay any principal balance during the interest-only period.
Another important point: Revolving debt like a credit card is non-amortizing. You can make a monthly payment consisting of mostly or all interest and carry the principal balance forward to the next month.
A Smart Move
Despite amortization, buying a home is still one of the savviest financial choices when compared to renting. The interest you pay to your lender is tax-deductible. Rent paid to a landlord is not. Plus, you’re building equity and generational wealth. If you have any questions about amortization and how to better prepare for your financial future, don’t hesitate to contact your loan officer.