Making the decision to buy a home and go through the home buying process can be daunting. There is so much to understand and do, from cleaning up your credit to saving money and finding the perfect house and home loans. For the 33% of people who buy a home for the first time, understanding all that’s a part of the process can be downright overwhelming.
Probably one of the more nerve-wracking parts of the process is getting financing for your home. These are big impactful decisions to make and understand. You might wonder, for example, what is amortization and how does it impact my mortgage?
There is an awful lot to learn quickly when getting a mortgage. It’s important to understand amortization since it helps you understand when you will own your home completely and be mortgage-free.
Read on to learn everything you need to know about mortgage amortization.
What Is Amortization?
Let’s start with an amortization definition to have some basic understanding. There are many real estate terms to understand, yet amortization is specific to your mortgage and mortgage payment.
Mortgage amortization is the process and numbers it takes to pay a mortgage down to zero and own your home completely. As the mortgage you carry on your home amortizes over time, you’ll pay more towards the principal and less towards the interest. Let’s understand these terms too.
The first part of understanding amortization is to know the term principal. Your principal is the original amount you borrowed to buy your home.
When you make a payment on your mortgage, some of the money goes towards interest and some towards the principal. Over time how much of the payment that applied to the principal increases and the amount paid towards interest decreases. This is part of the amortization.
Most homebuyers understand interest. This is how the lender makes money when they loan you money. The interest rate is what the lender charges you for using their money. Each month when you make a mortgage payment, a large chunk of that payment is for interest, while a smaller chunk is applied to the principal balance.
It’s smart when you’re considering your mortgage terms to look at a mortgage calculator so you can see how much interest you will actually pay over the life of the loan.
How Mortgage Amortization Works
If you have a fixed mortgage rate, your payment should remain close to the same over the life of the loan. The only thing that might cause a change is if you have a change in insurance or association fees.
Amortization uses your principal balance, the length of your loan, and your interest rate to calculate what your monthly payment will be over the life of the loan.
What happens over time with your loan is that you slowly reduce the principal balance, which means you have a smaller amount to pay interest on. This means that more of your payment can then go towards your principal. Early in a mortgage, much of your payment is actually towards interest. Whereas, when the mortgage is in the later years, more of the monthly payment goes towards principal than interest.
The mortgage amortization formula is a mathematical formula that the lender uses to calculate the mortgage payment amount. That formula goes something like this:
The interest rate is divided by 12 to get the monthly interest rate
Then take the number of years of the mortgage and multiply by 12 to know how many payments will be made over the life of the loan
Then the monthly interest rate is calculated based on the number of payments
Remember though, the principal amount continues to change over time.
Is There Amortization With Every Mortgage?
Anytime you have a loan with a set number of years there is amortization. Most lenders don’t participate in balloon mortgages anymore.
Since paying off loans for a mortgage is usually the goal, most homeowners want a mortgage with a pre-established life for the loan. This means an amortized loan is guaranteed to be paid off at the end of the life of the loan.
Amortization Only Applies to Mortgage Interest and Principal
It’s important to remember that amortization only applies to the principal and interest rate on a mortgage. There are things that are typically part of a mortgage payment that may adjust the payment over time. These include:
Private mortgage insurance
Homeowners Association (HOA) dues
Payments towards any of these things won’t have an impact on the mortgage amortization schedule.
Mortgage Amortization Schedule
Your mortgage lender should be able to show you an amortization schedule for your loan. This chart should include:
The number of months of the life of your loan
The amount of interest paid from that payment
The amount of principal paid towards the balance from the payment
The remaining balance of the loan
When you look at the amortization schedule as a whole, the one obvious thing you should notice is how much more interest you pay early in the mortgage compared to late in the mortgage. In most cases on a 30-year fixed-rate mortgage, it isn’t until year 19 that the amount of principal paid with payment is greater than the amount of interest.
Building Equity in Your Home and the Role of Amortization
The goal over time is, of course, to pay off your loan. Many people also watch the amount of equity they have built up in their home. The way to build equity is to pay down the principal.
Simply paying a small amount each month additional towards your mortgage can greatly reduce the amount of interest you pay over the life of the loan and increase your equity more quickly than the amortization schedule shows.
Understanding the Role of Amortization in a Mortgage
When you understand the question of what is amortization, it can help you understand how a mortgage company comes up with your monthly payment and what the mortgage will cost you over its lifetime.
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