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Mortgages are loans that borrowers use to buy a property. Since they usually have equal monthly payments, they are considered “amortizing loans.”
Let’s find out more about the process of loan amortization and go into the specifics of mortgage amortization in particular.
What is Amortization?
Amortization, in terms of loans, is the process of repaying the balance of a loan following an amortization schedule consisting of fixed monthly installments for a set period of time.
In short, each payment consists of two main elements – principal and interest. In the beginning, the portion towards the principal is very small and the majority of the monthly payment covers the interest. Over time, this changes and at the end, the monthly payment consists primarily of principal.
When explaining amortization, people usually mingle the term with depreciation.
The former, as already mentioned, refers to the repayment of a loan balance at a fixed interest rate and term. Depreciation, on the other hand, refers to the loss of value of a specific asset over time. Nothing in common, actually.
What is Mortgage Amortization?
In particular, a mortgage amortization is a home loan that you take in order to purchase a property.
Normally, mortgages are long-term loans with maturity over 20 years – 25 or 30 years. Sometimes, however, people choose shorter terms – 20 or 15 years. Keep in mind that this means that their monthly payment will be significantly higher. Not only does the amortization period (maturity) determine how much you have to pay monthly but also the overall interest on the balance. Longer periods usually mean lower monthly payment. What’s more, it means that the overall costs of the loan will be higher.
Each person should consider different options and determine which one suits them best at the moment. Are you willing to pay a lot more for the sake of a lower monthly payment?
What is An Amortization Schedule?
One of the main components of an amortizing loan is its amortization schedule.
This is a table in which the borrower can see several things:
- Each month
- The total payment
- The interest payment
- The principal payment
- The balance of the loan
|Date||Interest||Total Interest Paid||Principal||Total Payment||Balance|
To begin with, you can see that each month the borrower owes the lender $2,148. This does not change (which is the reason why these loans are called amortizing). However, you can see that the two portions which comprise one monthly payment will change:
In the beginning, the interest portion is much higher than the balance portion. In our case, $1,667 is an interest payment and only $481 goes towards the balance. The second month, the interest payment decreases and the principal portion increases. This is how it goes until the last payment, which consists only of a principal payment which fully pays off the balance of the loan.
When creating an amortization schedule, we assume that there are only 12 dates in a year, these are actually the 12 months. The specific day on which your account starts is the day that follows the day you close the mortgage. Your first monthly payment will be on this day, one month after. For instance, if you close your loan on 25 November, the account will be active on 26 and your first payment will be due on 26 December.
If you want to have a more general idea of how much your loan will cost, I recommend using an online mortgage calculator.
How To Calculate An Amortization Schedule?
In this paragraph, I’ll show you how manually to make an example amortization schedule. This will help you understand the whole process better and your own schedule once you take out your loan. You need to know four things – the term of the loan, the monthly payment for the whole period, the interest rate and the balance of the loan.
In our case, let’s imagine we have a $400,000 mortgage, with a 30-year term and at 5% interest rate. In addition to that, your monthly payment will be $2,148 throughout the whole period. Follow these simple steps:
1. Multiply the balance of the loan by the periodic interest rate, which is 1/12 of 5% (there are 12 months in a year. $400,000 by 0.00416=$1667. This, logically, is the interest payment for the first month
2. Subtract the interest payment from the monthly payment. $2148 – $1667=$ 481. This amount is the principal payment.
3. Now, we have to calculate the payments for the second month. Subtract $481 from the balance of the loan ($400,000). The result is $399,519. Then, repeat steps 1 and 2 using the new balance and you will see how much you owe in interest and principal payment for the second month.
4. Repeat steps 1, 2, 3 for the rest of the term and you will have an idea how amortizations schedules are made.
Advantages of Mortgage Amortization
- Fixed monthly payment – this is a huge advantage since the borrower is sure that his payment will not change all of a sudden, for example after the 5th Usually, this is the more manageable option.
- All borrowers have individual amortization schedules that conform to their financial status and ability to repay. In addition, sometimes borrowers can opt for flexible interest rates for a limited period of time. They can be either fixed or variable depending on the client’s wishes.
- The interest payment will get lower and lower as time goes by. With time, the principal of the loan will decrease, therefore the interest payment will go in the same direction.
Disadvantages Of Mortgage Amortization
- If you want to reduce the whole cost of the loan, you have to make larger payments so that the balance will decrease. Most people cannot afford to do that and of course, the overall interest they pay eventually is very high, especially if the term is long.
- With amortizing mortgages, the equity is not built “on the front end”. This means that first you start paying the interest and then the principal. Sometimes for the first 5 years, borrowers have a very low equity due to the fact that most of their payments go as an interest portion.
- Consumer advocates (people who protect the rights of customers) are also against mortgage amortization.
Mortgage Amortization And Refinancing
Refinancing is the process of taking out a new loan in order to replace one already existing. People usually do that for better terms.
What is the connection between mortgage amortization and refinancing?
You already know that mortgages are loans with long terms. Therefore, if you consider refinancing your loan that might have an impact on your amortization schedule. The main reason borrowers refinance is to have a lower interest rate and lower monthly payments. The bank can also agree to extend the term without lowering the rate when refinancing.
A 25-year mortgage at 5% and you have been paying for 10 years. Let’s assume that you want to reduce your monthly payment and the bank agrees to refinance your mortgage at the same interest rate but for 30 years. The amortization process will start again and you will have a brand new amortization schedule. There is an option for you to keep the same amortization schedule: if you refinance the loan at a term that is the same as the remaining years (15 in our case).
This could prove to be a serious drawback and risk, though. Imagine you have paid only 5 years for a 30-year mortgage. The equity will be very small. Should you refinance, you start again almost from zero. So, you will eventually end up paying a lot more in interest than in principal payments.
Mortgages are amortizing loans, which means that you pay the same amount of money each month for a preliminary fixed period. Each amortizing loan has its amortization schedule – a table that shows each payment and breaks it down to interest and principal.
Understanding the whole process is key to becoming a responsible borrower.