(Updated October 2014)
If you have ever shopped for a mortgage, you've likely heard the term "amortization" thrown around. While it might sound like an intimidating concept, amortization is actually quite easy to understand.
Simply put, amortization is the process of repaying a loan over time by making regular payments on a predetermined schedule. It can also refer to the gradual reduction of the outstanding balance, or principal, owed on a loan through that process. Those may sound like the same thing, but there's a subtle difference between the two, which we'll get to later.
The basics of amortization
On a fixed-rate mortgage, the loan is amortized by making regular, equal payments according to a strict schedule. For example, if you have a 30-year fixed rate mortgage, you will pay the same amount ever month for 30 years until the loan has been paid off.
The key feature of amortization is that the loan is paid off on a particular timetable through regular payments designed to meet that schedule. That doesn't necessarily mean that all the payments will be equal, although they often are.
On an adjustable-rate mortgage (ARM), for example, your monthly payments will vary whenever your mortgage rate adjusts. However, those payments will still be designed to pay off the loan on a predetermined schedule - usually 30 years on an ARM. So an ARM may be designed for a 30-year amortization, but the payments will vary as the interest rate adjusts.
Something like a credit card is not typically thought of as an amortized loan because the loan balance and payments tend to fluctuate month-to-month depending on the borrower's spending habits. However, if you were to stop using the card and begin paying it off in equal monthly installments, that would produce an "amortization schedule" that would allow you to predict when you would have the debt paid off.
Paying down principal
As mentioned above, amortization doesn't just mean the process of paying off a debt by making consistent payments on a regular schedule. It also refers to rate at which you pay down the principal on that loan.
Here's why that's an important distinction: When you take out a long-term loan such as a mortgage, most of your monthly payments go toward interest costs during the early years of the loan. That's because interest is charged on the balance you still owe, and in the early years you haven't had much time to whittle down the principal yet.
Later on, as the loan balance shrinks, more of your payment can go toward the mortgage principle, and you start paying down the balance ever faster. In fact, on a 30-year mortgage you'll commonly pay off half the principal in the last 10 years of the loan!
One important consequence of this is that the amortization rate will affect how quickly you build equity in your home. That affects your financial security, as the more equity you have, the less vulnerable you are to foreclosure should a financial crisis occur. Home equity also affects how soon you can afford to move up to a nicer home, should you chose to do so, your ability to qualify for home equity loans, or whether you can cancel payments for mortgage insurance.
Amortization schedules and tables
The amortization period is the length of time that it will take to pay back the borrowed money. On mortgages, this may range from 10 to 40 years. The total amount that you pay over the life of the loan will be determined by 1) the amount you borrow 2) the interest rate and 3) the term, or length, of the loan. If you have a longer mortgage term you will end up paying more in interest. For example, you'll pay about $70,000 more in interest over the life of the loan on a $200,000 30-year fixed-rate mortgage at 5 percent than you would on the same loan paid off over only 20 years.
This process by which the loan principal gradually is paid down at an ever-accelerating rate is called the amortization schedule. A chart that shows this process, including the changing amounts going to principal and interest and the gradually declining loan balance, is called an amortization table. Many online mortgage calculators will produce these automatically, which allows you to adjust various factors such as interest rate, discount points and down payment and compare the results.
Seeing the information on an amortization table is eye-opening. It allows you to see how much interest you are paying on loans of varying lengths. Also it helps to understand the value of various programs that allow you to pay down the principal of your loan early, which will lower your interest payments.
Knowing how amortization works is essential to understanding mortgages. The concept itself isn't that difficult, although working out the actual numbers may take a bit of figuring out. But having a good handle on the process will help make you a savvy mortgage shopper and make informed financial decisions.