What is amortization? How does it work? Many people have asked these questions and have been offered complex answers that have left them even more confused than before they asked. Here is as simple an explanation as you are likely to get, particularly with reference to mortgage amortization
Mortgage Amortization Fundamentals
When you take a loan of any sort, you want to repay the same amount every month. There are loans where you can start paying less and end up paying a lot more, but most people like to make the same monthly payment every month over the term of the loan – whether that is a car loan, personal cash loan or a mortgage loan.
The interest on your loan can be arranged in a number of ways. It can be charged daily, weekly, bimonthly or monthly according to the agreement you signed. Most mortgages apply the interest monthly in advance. Let’s say you have a loan of $150,000 over 30 years at 4% interest.
Annual Mortgage Amortization
If we start the calculation on the first day of the month, then:
On day 1 of year 1 you are due 4% of $150,000 = $6,000 interest, plus your principal repayment: $150,000/30 = $5,000. That makes $11,000 mortgage payment due for year 1. Obviously you could likely not pay that in addition to your down payment and closing costs.
If it is agreed that you make equal monthly payments for year 1, then that would be $916.67 each month for the first year. That might be more affordable. The following year would then be calculated assuming you only owed $145,000 ($150,000 – $5,000). You would then pay less that year since your interest would be less, but you would still make the same annual $5,000 payment off the principal.
Amortizing a Mortgage Monthly
Take that to a monthly basis: each month your principal payment would be $5,000/12 = $416.67 and your interest would be based upon the principal still owed at the start of that month.
What this means is that your initial payments would be high, because you are paying interest on the full amount still owed. Interest would become increasingly lower as the year progressed because the principal would be getting less. Your payments later into your 30 years would be much lower, because your total sum would be less, and so the interest charged at the beginning of each month would less.
What is Mortgage Amortization Today?
What is amortization in terms of today’s mortgages? Let’s take the above examples to the extreme. Take:
Total reducing monthly interest paid over 30 years + total monthly principal payments due after each month
Divide that total 30 year figure by 360 to come to an average monthly payment. That’s how mortgage amortization works. Amortization is a system that calculates your total payments over the 30 years, and divides them by 360, so you make the same payment each month. You pay exactly the same monthly mortgage payment for the full 360 months.
What is Amortization?
Let’s come back to the original question, ‘what is amortization?’ Amortization of any loan, including mortgage amortization, is a financial tool that enables borrowers to repay their loan at the same amount every month. Without it, you would pay considerable more at the start of your mortgage term and less at the end – the opposite of what would likely be ideal for you.