An Amortization Primer
- By:
- Tom Kerr | December 10, 2007
Although most of us don't understand exactly how our loan payments are calculated, the process of paying off a loan through a fixed number of payments is common to all mortgages. The amount paid each month is predetermined by a mathematical procedure known as amortization.
Amortization of a loan is the systematic repayment of both the principal and interest over a specified period of time. Calculating amortization is complicated, but here's a simple guide to how it works: A schedule of payments is constructed that accounts for both interest and principal. The total amount is then divided by the length of the mortgage. For loans that are fully amortized, the installments remain essentially consistent until the entire obligation is paid. For partially amortized loans, a large lump sum payment is normally necessary at the end of the loan.
Each installment consists of a principal portion and an interest portion. On your mortgage payment coupon or invoice, this should be clearly delineated. The amount of interest that you owe will change every time you chip away at the principal. For example, if you owe $100,000 in principal, the interest owed is based on that amount. But, if you make a principal payment of $1,000, it will reduce your balance to only $99,000. The next time that you make a payment, you'll only pay interest on $99,000 instead of $100,000. Every time that you make a payment, the interest needs to be recalculated to take that into consideration.
The business of keeping up with all the recalculations can become quite complicated, and could potentially disrupt your ability to predict how much your house payment will be each month. That's where the process of amortization comes in handy. The useful thing about it is that it calculates all periodic changes and fluctuations beforehand, and then mathematically arrives at an appropriate monthly payment amount that will remain the same for the entire time that you're paying off your loan. If you have a fully amortized fixed-rate 30-year mortgage, for example, you make the same monthly payment for 30 years. At the end, you'll have fully paid off all your principal and interest.
With a partially amortized loan you also make equal monthly payments of principal and interest, but they're not enough to pay off the entire loan in the allotted length of time. To completely retire the mortgage debt, you must make a lump sum payment at the end of the loan. For instance, on a partially amortized 10-year loan, you'll have a balloon payment due at the end of 10 years.
Most amortization schedules are structured so that during the first half of your loan's life, you pay mostly interest, and during the last years of the loan, you pay off the principal in larger chunks. The easiest way to view all the calculations in detail is to use a published amortization table, such as those provided by your lender, prior to closing.
Amortization of a loan is the systematic repayment of both the principal and interest over a specified period of time. Calculating amortization is complicated, but here's a simple guide to how it works: A schedule of payments is constructed that accounts for both interest and principal. The total amount is then divided by the length of the mortgage. For loans that are fully amortized, the installments remain essentially consistent until the entire obligation is paid. For partially amortized loans, a large lump sum payment is normally necessary at the end of the loan.
Each installment consists of a principal portion and an interest portion. On your mortgage payment coupon or invoice, this should be clearly delineated. The amount of interest that you owe will change every time you chip away at the principal. For example, if you owe $100,000 in principal, the interest owed is based on that amount. But, if you make a principal payment of $1,000, it will reduce your balance to only $99,000. The next time that you make a payment, you'll only pay interest on $99,000 instead of $100,000. Every time that you make a payment, the interest needs to be recalculated to take that into consideration.
A handy mortgage tool
The business of keeping up with all the recalculations can become quite complicated, and could potentially disrupt your ability to predict how much your house payment will be each month. That's where the process of amortization comes in handy. The useful thing about it is that it calculates all periodic changes and fluctuations beforehand, and then mathematically arrives at an appropriate monthly payment amount that will remain the same for the entire time that you're paying off your loan. If you have a fully amortized fixed-rate 30-year mortgage, for example, you make the same monthly payment for 30 years. At the end, you'll have fully paid off all your principal and interest.
With a partially amortized loan you also make equal monthly payments of principal and interest, but they're not enough to pay off the entire loan in the allotted length of time. To completely retire the mortgage debt, you must make a lump sum payment at the end of the loan. For instance, on a partially amortized 10-year loan, you'll have a balloon payment due at the end of 10 years.
Most amortization schedules are structured so that during the first half of your loan's life, you pay mostly interest, and during the last years of the loan, you pay off the principal in larger chunks. The easiest way to view all the calculations in detail is to use a published amortization table, such as those provided by your lender, prior to closing.
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