Understanding Amortization
July 3, 2023
What is Amortization?
Amortization refers to the process of paying off a loan or mortgage through monthly principal and interest payments over a set period. With a fixed-rate mortgage, the amount dedicated to principal and interest will change each month, but the payment will remain the same each month until the mortgage reaches its maturity date or is repaid, whether that is through the sale of the home or by refinancing. The amount that is dedicated toward interest will be the highest at the very beginning of the mortgage term and will gradually decrease over the life of the loan.
Calculating Amortization
While amortization can be calculated using a financial calculator or Microsoft Excel, there are online calculators that make it much easier to calculate. An amortization schedule calculator can reveal how much your monthly payment will be and how much you will pay in interest over the life of the loan by inputting your mortgage amount, mortgage term (in months or years), and interest rate. It will also break down the amount dedicated toward principal and interest during any particular month, the total amount of principal and interest that have been paid after a specific amount of time, how much you still owe at a particular point, and how many payments you can eliminate by contributing extra toward the principal. One benefit of knowing the total amount you have paid toward the principal is that it will reveal how much equity you have in your home.
Comparison of Amortization Periods
Two of the most common terms for fixed-rate mortgages are 15 years and 30 years. A longer amortization period, such as 30 years, allows for a lower monthly payment, but a higher interest expense over the life of the loan. In contrast, a shorter amortization period, such as 15 years, will allow you to build equity in your home quicker, but your monthly payment will be higher. Choosing the amortization period that is right for you will depend on several factors, such as the down payment amount you are able to put toward the home, your debt-to-income ratio, other expenses, and more.
Common Terms Associated with Amortization
To fully grasp the concept of amortization, it helps to have a basic understanding of the terms associated with amortization. The definitions below provide a foundation.
- Period: How frequently loan payments are due, as represented by each row in an amortization schedule. The most common period is monthly, but other options include bi-weekly, quarterly, etc.
- Payment: Equal to the sum of principal and interest owed during each period. If you agree to a fixed-rate mortgage, the payment will remain constant over the term of the loan
- Interest: The outstanding loan balance multiplied by the interest rate relevant to the specific period. For example, if a payment is owed monthly and the annual interest rate is 5%, you would divide 5 by 12 to get a monthly rate of 0.004167. The interest expense decreases as the loan balance decreases
- Principal: The remaining amount of the payment after interest is calculated. The portion dedicated to principal increases as the loan balance decreases
- Beginning Loan Balance: The amount of debt owed at the beginning of a period. This amount could either be the original amount of the loan or the previous period’s ending loan balance
- Ending Loan Balance: The beginning loan balance minus the principal. For example, if you owe $200,000 and your most recent payment toward the principal balance was $350, the ending loan balance would be $199,650
Grasping the concept of amortization is one piece that will help you understand what you can afford as you look at homes and consider applying for a mortgage. As always, Mlend is here to answer any questions you may have about purchasing or refinancing a home.