What is Amortization?

Discovering how your mortage amortization schedule works is an important step in understanding the basics of your loan. Here’s a look at what is amortization and how it works.

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Amortization is loan repayment that’s based on equal monthly payments each month. Each payment is made up of interest and principle payments. Amortization schedules are typically made in such a way that most of the loan interest is paid earlier in the loan, with little going toward the principle balance. The interest portion of the payment decreases a little each month and principle payments increase. Using an amortization schedule lets both the borrower and the bank see how the loan will be paid over the repayment period.

Looking at an amortization schedule for your loan, you’ll see that the total amount repaid is larger than the amount you borrow. That’s because you must pay a cost to borrow money. That cost comes in the form of interest. Interest is front-loaded on the loan repayment allowing the bank to collect their fee quicker. Auto loans are typically amortized over a 3- to 5-year period of time. Mortgage loans are usually amortized in 10-year, 15-year, 20-year, or 30-year time periods.

How Amortization Period Affects Loan Amount

If the amortization period is longer, your payments will be smaller, but in turn you’ll pay a greater amount of interest relative to what you borrow. On the other hand, shorter amortization periods mean bigger monthly payments with less interest paid over the life of the loan. You can pay off your mortgage faster than scheduled – and thereby pay less interest – by paying more than the balance due. Before you send extra payments, make sure your mortgage doesn’t have a prepayment penalty, which would asses you a fee for paying off your mortgage sooner than scheduled.

Non-Amortizing Loans

Mortgages that have interest-only payments are not amortized for the period that the principle is not being reduced and the borrower is not gaining any equity in the asset the loan is used to purchase. Typically, the payments increase after a certain amount of time so the loan amortizes on schedule.

Negative Amortization

A loan payment is called “fully amortized” if making that payment each month would result in loan repayment by the end of the term. However, some mortgage payments
are below the fully amortized payment and result in an increase in the principal balance. This happens because the monthly-required payments are less than the interest due based on the amortization schedule. The deferred interest is added back to the loan and the balance grows instead of shrinks. This can happen with both fixed and adjustable rate mortgages in graduated payment and payment option mortgages, respectively.

The downside of negative amortization is that the monthly payments must increase at some point in the mortgage so the loan can amortize on schedule. Loan payment may increase significantly several years into the loan resulting in payment shock. Or, there may be a one-time balloon payment due on the mortgage due several years into the loan. If you can’t afford the increased mortgage payment or the balloon payment and you can’t refinance your loan before the payment is due, you risk losing your home
in foreclosure.

Some borrowers benefit from negative amortization mortgages because the initial payments are low and affordable. However, these do not come without risk. Borrowers with these types of mortgages must be aware of the impending payment increase and be sure they can afford the increased payment when the time comes.

The loan may have a negative amortization limit that’s either a fixed amount or a percentage of the loan. Your loan payment will automatically adjust so the loan can be fully amortized by the end of the repayment period.

Using an Amortization Calculator

You can use an online amortization calculator or this amortization schedule spreadsheet (Excel) to print an amortization schedule based on your loan amount, interest rate, and repayment period. The amortization table will let you know your total monthly payment, the amount of the payment that goes toward interest, the amount of the payment that goes toward principle, and the amount of principle owed after making each monthly payment.