Understanding amortization is especially important for homeowners, as mortgage loans are one of the most common forms of amortized loans. Amortization refers to the repayment of a loan through scheduled periodic payments. This type of loan differs from conventional loans in the way the structure and amount of each payment is calculated. In this post, we will discuss amortization in further detail and explain how it applies to mortgage loans.
Calculating Payments
The payments on amortized loans are determined differently from those of other kinds of loans. To calculate the payment on an amortized loan, the principal, or the outstanding balance of the loan after deducting the down payment, is divided by the number of months the borrower has to repay the loan. Interest is then added. The interest rate is calculated on the basis of the buyer’s credit, the current market rate, and the term of the loan, typically 15, 20, or 30 years. Every payment reduces a portion of the interest first and then a percentage of the principal.
Amortization & Home Loans
Mortgages payments are probably the most familiar example of amortized loans. In fact, the words “mortgage” and “amortize” share the root “mort,” meaning to kill. In other words, amortized payments “kill” the loan off in small increments. For fixed rate mortgages, the monthly payment is usually the same for the life of the loan. To learn whether you can afford to buy a new home, you can consult any number of amortization calculators online.
Amortized vs. Interest-Only Loans
Some borrowers conflate amortized loans with interest-only loans, but the two are very different. With an interest-only loan, the entire amount of your monthly payment is applied toward the interest. None of your payment is applied toward the principal. However, borrowers can make supplemental payments to pay down the loan’s principal, though it is not required initially. With an amortized loan, though most of the monthly payment is applied toward interest at the beginning of the term, a part of the payment is also applied to a portion of the principal. Usually, with an amortized home loan schedule, it will take about half of the loan’s term or longer for the amounts of the principal and interest payments to be equal. Later in the life of the loan, the portion of the principal being paid begins to outstrip the amount of the interest payment, which helps reduce the outstanding balance more rapidly.
Extra Payments
In order to pay an amortized loan off faster, borrowers can make a monthly payment in excess of the minimum required amount and request that it be applied to the principal. Because interest is the product of the loan’s interest rate multiplied by the principal, a lower principal will result in lower interest payments. Making additional payments every month can help reduce interest expense in the long term and shorten the life of the loan. If you choose to make extra payments, be sure to specify to your lender that you would like the additional amount to be applied to the loan’s principal.