“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. And an amortization calculator will show you how your balance is paid off on a monthly or yearly basis.
Early Payments Go Toward Interest
During the first half of a 30-year fixed-rate loan, most of the monthly payment goes to paying down interest, with very little principal actually paid off. 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 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.
Consider Biweekly Payments
Be sure to look into biweekly mortgage 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, lowering the total amount of interest paid and decreasing the term of the loan.
Every potential homeowner should use an amortization schedule or a mortgage calculator to determine exactly how payments apply in their particular situation. Simply knowing your interest rate is not enough to make an educated decision on a loan product.
And be sure you understand negative amortization as well, assuming if you got involved with a pesky option-arm loan.
