What Is Mortgage Amortization?
Amortization is a term that’s closely associated with mortgage loans, and may be an unfamiliar concept at first glance. But it’s an important concept to understand, as a buying a home and taking out a home loan is one of the most important financial decisions most people will make during the course of their life.
Amortization is actually much simpler than it sounds. It is merely the process by which payments against the outstanding loan balance are applied to both the principal and the interest. On a fixed-rate mortgage, as monthly payments are made, the portion of each payment applied to interest goes down and the portion applied to the principal goes up.
How does amortization work over time?
The amortization schedule for a mortgage shows how much of each payment will go towards interest and how much will go towards the principal, for every payment scheduled over the life of the mortgage.
Take for example a 30-year, $325,000 mortgage with a fixed interest rate of 4.5%. The monthly principal and interest payment (rounded to the nearest dollar) would be $1,647, with $428 of the first month’s payment applied to the principal and $1,219 paying down interest.
Interest gets paid before principal
Why does so much get applied towards interest? The interest payment is calculated by dividing the 4.5% annual interest due over the twelve monthly payments. One-twelfth of 4.5% (0.045) is 0.00375. Multiplying 0.00375 by the outstanding principal of $325,000 determines the amount of the interest payment, which is $1219. The remaining amount of the first monthly payment, $428, is then applied to the principal.
For the second month of the loan, the principal has now been reduced by the first month’s payment. In our example, the principal would now be $324,572. Multiplying this amount by the same interest factor of 0.00375 results in an interest payment of $1,217; slightly less than the previous month. So on the second payment, $430 would be applied to the principal.
These calculations are repeated month after month, with slightly more of each payment going to principal. At about the half-way point of the loan – 15 years in this case – each payment will be split about 50/50 between principal and interest. And after about year 20, more than $1,000 of each payment will go to the principal.
Changing the amortization schedule
The amortization schedule assumes the minimum payment will be made each month. But if the borrower pays an additional amount toward the principal at any time, the following month’s principal balance will be lower than scheduled, which will also reduce the amount of interest due. So even making small extra payments towards principal will shorten the term of a mortgage and reduce the total amount of interest paid over its life.
Do you have a question about mortgage amortization schedules or other home loan details? Contact Torrance Mortgage Broker Shawn Carvin today for a free analysis. Shawn is a licensed California mortgage professional with nearly 30 years experience in the financial services industry, half of that focused on mortgage lending. Shawn works with clients throughout the greater Los Angeles area including Torrance, the Palos Verdes Peninsula, the Beach Cities, other South Bay communities, and beyond.