Amortization
Amortization is defined as the reduction of debt by regular payments of interest and principal sufficient to pay off a loan by maturity. In simple terms, it’s the way your mortgage payments are distributed on a monthly basis, detailing how much interest and principal will be paid off each month for the duration of the loan term.
Understanding the way your mortgage amortizes is a great way to understand how different loan programs work. An amortization calculator will show you how your balance is paid off on a monthly or yearly basis.
During the first half of a 30 yr loan, most of the monthly payment goes to interest, with very little actually paying off the principal. Towards the last 15 years of the loan you will begin to pay off a greater amount of principal, until the monthly payment is largely principal, and very little interest. This is important to note because homeowners that continuously refinance will find themselves back in the interest-paying portion of the loan every time they start anew.
Let’s look at an example:
Say you’ve got a $100,000 loan at 6.5% on a 30 year fixed payment. The monthly principal and interest payment is $632.07. The first payment is broken down into $541.67 towards interest and $90.40 towards principal. The total debt is reduced by $90.40, so next month you’ll only owe you only owe interest on $99,909.60.
So when it comes time to make your second payment, interest is calculated on the new, lower balance. The payment would be $541.18 towards interest and $90.89 to principal. This interest reduction would continue until your monthly mortgage payments were going primarily to principal. In fact, the 360th payment contributes $3.41 to interest and $628.66 to principal.
Be sure to look into bi-weekly payments as well. These are mortgage payments made every two weeks, which equates to 26 total payments a year, or 13 monthly payments. That extra month payment per year goes to principal, decreasing the term of the loan and lowering the total amount of interest paid.
Every potential homeowner should use an amortization schedule or a mortgage calculator to see exactly how payments apply to their particular situation. Just knowing your interest rate is not enough to make an educated decision on a loan product. Also be sure to understand negative amortization as well, if you got involved with an option-arm loan.
