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How Does Mortgage Amortization Work?

amortization-schedule

Real Estate

How Does Mortgage Amortization Work?

A mortgage is simply a big loan or debt. Therefore, the best we can do is reduce its term or duration. This is possible by prepaying a significant portion of the loan quickly.

In case you are wondering why you should know that owning a house free and clear is not a bad place to be.  When you live in your home without having to worry about mortgage payments, that is when you will start saving considerable money. In other words, life becomes easier. The aggregate interest on a mortgaged loan makes the outstanding loan even bigger.

For instance, a mortgage debt of $210,000 will cost you about $360,000 in monthly repayments over a period of 30 years. By shortening the debt term, you can make significant savings.

Meaning of Mortgage Amortization

Amortization is the built-in payoff calculation. It is a vital element of most mortgages. Moreover, it is the best tool that can help you repay your loan. Amortization is simply the difference between mortgage payments (made monthly in most cases) and the interest element they contain.

If you make prepayments on your mortgaged loan, by increasing your monthly payments or by making periodic or occasional lump sum payments, you will be able to reduce the amount owed as well as your monthly interest payments. With a decrease in the interest component of the payment, your principal portion will increase, and thereby, the outstanding term of your loan will get shorter.

By repaying your debt in 20 years rather than 30, you will save almost $110,000 in repayments (based on a loan of $210,000), sparing funds for other investments.

Amortization: The Good and Bad Aspects

The good part about amortization is that it provides a guaranteed means to repay your mortgaged loan. Even when you do not make extra payments, due to amortization, you will own your house without any encumbrance when the loan term ends.  Moreover, your equity in the house will increase with each payment.

The bad aspect, however, is that amortization is usually extremely slow. As interest expenses on a mortgage, are front-loaded (you pay a significant part of the interest cost in the initial years, you will repay a majority of your outstanding principal in later years), you will have to wait many years into the mortgage before you will start to see any substantial drop in your outstanding loan.

However, if you make prepayments, you will accelerate the process of amortization, which will enable you to repay your mortgage early.

An Example of How Mortgage Amortization Works

An ideal way of getting familiar with mortgage amortization is to understand it with an example.

Assume you have taken out a loan of $200,000 with a term of 30 years and the rate of interest is 4.00%; this is what the numbers will be at different intervals:

Commencement of Loan, Initial Payment:

Monthly repayment: $954.83

Interest component: $666.67

Principal component: $288.16

Outstanding loan: $199,712

After 5 Years, Payment # 61:

Monthly repayment: $954.83

Interest component: $602.98

Principal component: $351.85

Outstanding loan: $180,543

After 10 Years, Payment # 121:

Monthly repayment: $954.83

Interest component: $525.23

Principal component: $429.60

Outstanding loan: $157,139

As it is evident from the above example, almost 70% of your initial payment is the interest component. Therefore, you are barely able to make a dent in your outstanding loan. You will repay less than $3,500 of your principal in the initial year of your loan.

Even after five years, your principal monthly component has increased by only $64 and 90% of your original outstanding principal is still owed! You will need to reach repayment number 153. This will be exactly 12 years and nine months into your mortgage term. At this point, the principal component of the payment will first edge out your interest component! At this stage, almost 13 years into your loan, you will still owe $142,609 in principal. This amount is over 70% of your outstanding loan. And yes, you are almost midway through the term of your loan!

This amortization example illustrates that amortization is a painfully slow process; therefore, it is crucial to prepay the mortgaged loan as soon as practicable. You can play around with various mortgage calculators to determine the amount of money that you can save by expediting the process of amortization with additional payments. A lump sum or even a modest amount each month or on occasions may make a considerable difference.

Amortization and Refinance

As amortization tends to work very slowly, considering its impact on refinancing is important to determine when you will own your house mortgage-free. The primary reason behind refinance is that most people want to reduce the monthly payments.

You can refinance either by securing a lower rate of interest on your loan or by lengthening the duration of the new debt. In case you are ten years into a loan with a term of 30 years, and you decide to refinance it into another loan of 30 years, the new repayment will be slightly lower, but you will have to start the amortization process anew. The ideal course of action is to keep the original repayment schedule intact. You can set the duration of your new debt equal to or less than the remaining period on your old debt.

Reverting the mortgage to its original term will retard the amortization process and will rob you of the best opportunity to repay it. Always bear this in mind, whenever you think about refinancing.

Final Thoughts

Amortization sets up your loan in such a way that it takes a certain period to pay off.  With time, some part of the payment covers the interest, and the rest covers the principle.  These proportions will change with time.

Mortgage amortization causes you to pay considerably more interest than principle in the beginning. You should realize that the sooner you start to pay more toward the principal, the sooner your equity will build up and you will repay the loan faster. Mortgage amortization can work both ways. It can help you or hurt you. All depends on the way you use it.

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