What is amortization | Everything you should know
With mortgage rates expected to continue rising, it’s easy to focus on your interest rate when trying to reduce your payment.
But another factor can have an even bigger impact on your monthly mortgage payment – amortization.
Amortization is the period over which you pay back a loan. For most mortgage loans, it is 30 years or 15 years. It affects how much interest you pay over the life of the loan and how quickly you build equity in your home, says Scott Nguyen, a licensed real estate agent and owner of Oakland, Calif.-based mortgage brokerage Made Mortgage. It’s also the stabilizing force that can hold the principal and interest portions of your monthly payment for the duration of the repayment period, Nguyen said.
But not all loans are fully amortized, which has its pros and cons. With interest rates rising this year, it’s important to understand how your loan’s amortization schedule affects your financial future.
What is amortization?
Loan amortization is the process of determining the monthly payments required to pay off the balance in a given time frame. For example, a mortgage loan that has been amortized over 30 years will be paid off in full after 30 years of amortization. With a 30-year fixed-rate loan, you typically make the same monthly mortgage payment every month for 30 years.
While each monthly payment can be the same amount, it’s important to understand that each mortgage payment can use different amounts for principal and interest, says Mai Huynh, underwriting manager at online mortgage lender Better.com. “With a brand new loan, the majority of your payments will be used for interest. And the longer the term of the loan, the more interest you pay over the life of the loan.”
If you can afford larger payments, a shorter loan term can save you tens of thousands of dollars over the life of the loan.
An amortization table shows how each payment on a loan counts toward principal and interest. Understanding how to read an amortization table can be especially helpful for buyers who need to calculate personal mortgage insurance (PMI), Nguyen says. PMI can usually be removed once a homeowner has 20% equity in their home, he said. With a payback table, homeowners can see exactly when they can request PMI removal and plan for the additional monthly savings.
Which loans are amortized?
There are many different types of loans, and not all are repaid at the end of the loan period. These types of loans are known as non-amortizing loans.
While the monthly payments on an unamortized loan don’t pay off the entire loan balance, they do have certain benefits. You might have lower or no monthly payments, but you might have to make a lump sum payment at the end of the loan.
Here are a few different types of amortizing and non-amortizing loans.
Classic mortgage loan with a fixed interest rate: A typical traditional fixed rate loan has equal monthly payments over a period of time, typically 30, 20, 15, or 10 years. This is considered a secured loan because your home is considered collateral if you default on the loan.
Variable rate mortgage loan: An adjustable rate mortgage (ARM) typically offers lower introductory interest rates than a fixed rate mortgage loan, typically 1, 3, 5, 7, or 10 years. While the change in interest rates could affect the amount of monthly mortgage payments, making regular, timely payments will still amortize the loan balance at the end of the loan term.
car loan: A car loan is similar to a mortgage loan, but a vehicle is collateral instead of a home. Auto loan payments are typically equal monthly amounts paid over 3 to 7 years.
private loan: Borrowers can use personal loans for almost any reason. These loans usually have higher interest rates because they are unsecured loans.
Home equity line of credit (HELOC): A home equity line of credit (HELOC) is like a credit card that is backed by your home’s equity. A lender grants you access to a line of credit based on the equity you have in your home, and you can draw on that line of credit for a period of time.
Interest-free loan: With an interest rate loan, borrowers can benefit from lower monthly payments because the payments only cover the interest portion of the loan during a non-interest period.
Balloon Mortgage Loan: Balloon loans either have no monthly payments or lower monthly payments compared to traditional mortgages. However, at the end of a certain term, a borrower has to pay off the loan with a one-off payment.
Deferred interest loan: Loans with deferred interest allow the borrower to avoid paying interest for a period of time. If the loan is paid off before this period expires, the borrower usually owes no interest. However, if the loan is not repaid, interest will accrue.
Amortization vs. Depreciation
Amortization and depreciation are similar concepts, but there are differences. With an amortization schedule, payments are designed to reduce the loan balance to zero after a specified time frame. Depreciation reduces the value of an asset over a period of time.
Put simply, assets lose value when their useful life is shortened. For example, cars that have been driven for several years lose value in part because they are not expected to last as long as a brand new one.
Houses can also depreciate in value with normal wear and tear, but house appreciation can exceed depreciation. Homeowners can keep their property value high by being proactive with preventative maintenance, repairs, and renovations.
Examples of asset depreciation
- cell phones
How to read an amortization plan
Let’s go through an example of how to read a mortgage loan amortization schedule.
Using this amortization calculator on the left, enter a purchase price of $350,000, a 10% down payment, and a 30-year loan at a 4.7% interest rate.
- On the Payment Breakdown tab, you can see the monthly principal and interest payment of $1,633.
- In the Payment Breakdown section, you can also enter your monthly homeowners insurance, property taxes, and HOA fees.
- On the Amortization Schedule tab, you can see how each payment breaks down into principal and interest. For example, on the first monthly payment of $1,633, $399.25 is credited against the principal, while $1233.75 is credited against interest.
- With each additional monthly payment of $1,633, a larger portion is applied to the loan amount.
On the left side of the repayment schedule is the date of each payment. This gives you the ability to see the exact loan balance on any date and makes it easy to see when to get rid of PMI.