Investment Glossary – Amortization
This is one of those terms that if you look at it and don’t know what it means to begin with, you don’t really have a chance of figuring it out without a smattering of blind luck or a couple of beers. What amortization actually refers to is the process by which mortgage lenders, predominantly banks and credit unions, blend the expected interest from the loan into your monthly payment for your mortgage, so the payment does not change from month to month. Still confused? Let’s dig a little deeper.
Some loans, such as auto loans and credit cards, do not use amortization. If you’ve ever failed to pay off the full balance on a credit card or had an auto loan, you know that the interest from the prior month gets added onto the balance that you have to pay off for the following month. So if you hypothetically had $1,000 in outstanding credit card debt at a 24% interest rate, you would have $20 in interest that gets added to your next month’s bill. If you submit a payment of $100 to that bill, your balance will go down to $920, since you have to first pay the interest from the prior month, and then the remainder is paid towards the principal.
Mortgage underwriters understand that while this is practical when you are dealing with a $1,000 credit card bill, it’s probably going to mess up your budgeting and ability to pay your mortgage on time if your payment varies from month to month based on how much you paid the prior month. So instead, banks rely on amortization to give you a fixed payment every month in which that payment is systematically divided between principal and interest. Here’s how it works. The bank knows that you have a certain period of time to pay off your loan – let’s use 30 years in this example since that is the most common time period chosen for mortgages. They know your mortgage rate – they are usually fixed unless you choose an adjustable-rate mortgage. And so banks run some calculations and determine exactly how much principal and interest you have to pay each month in order to have the mortgage paid off at the end of that 30-year term.
Here’s a sample of how an amortization schedule looks, run using the Amortization Calculator from BankRate.com:
In this case, we look at a $200,000 home in which the buyer made a down payment of $40,000, leaving themselves with $160,000 in principal to pay off by the end of the 30 years. In the second column, labeled “Payment,” you can see that the monthly payment doesn’t change at all. But the next two columns, “Principal” and “Interest,” show that the amount allocated to each of these changes as more payments are made. Specifically, the amount of principal increases slightly each month as more principal is paid off and the interest outstanding on the loan decreases. It’s important to note that in the initial years of a mortgage, the money you are paying is predominantly going to interest, with the amount going to principal rising as you go through the term of the mortgage.
The use of amortization helps give homebuyers certainty regarding what they can afford to spend on a home, as well as helping banks to ensure that the regular schedule of payments keeps borrowers on track to repay their loan on time. It is important to note that the amortization schedule for an adjustable-rate mortgage may change if the rate changes from the prior period, so that is something you want to build into your planning. But the use of amortization generally makes the payment very predictable, which is a key component in trying to budget for your home purchase..