What is amortization and why should you care?
You're smack dab in the middle of the home buying process, and it's all new and exciting and a little confusing. You sorta get the process: you find a dream house, put down a down payment, and borrow the rest. Then — in just 30 years or 360 monthly payments — that dream house is all yours.
It all sounds so simple until your lender or real estate broker brings up “amortization.” Don't feel singled out: for many of us, buying a home (or a car) was the first time we ever heard the word, too. So even if you didn't have to reach for a dictionary or thesaurus, we encourage you to keep reading. Hopefully, this blog will help you understand what amortization is and how it works when paying down your home loan.
What exactly is amortization?
A monthly mortgage payment basically consists of two things:
- The principal, which is the amount of money you'll need to borrow to buy the house — minus the down payment
- The interest, which is the amount charged by the lender to borrow the principal amount.
To break it down, amortization is simply a way to equalize your monthly mortgage payment over the life of the loan. Over time, amortization adjusts the ratio of the principal paid to the interest paid.
When you start paying off your mortgage, the interest payment is high and the principal payment is low. As you get closer to the end of the loan, the reverse happens: interest payments are low and principal payments are high.
Amortization makes monthly payments on a home loan equal and more predictable, which can help homeowners better manage their finances, plan for expenditures like a new car or a kid's education, and have a little put aside for emergencies or extravagances like a well-earned vacation. Without amortization, your monthly mortgage payments could be all over the map every month.
How does amortization work?
When you first take out a home loan, regardless of whether you're buying a home or refinancing an existing mortgage, the balance of the loan is at its peak. That means the amount of interest you owe on the entire loan is also at the highest it'll ever be.
In theory, your lender could skip amortization and make the loan payments include equal portions of the principal balance. But it would quickly become a budgeting hassle to pay a different amount each month.
What if you didn't have amortization?
Let's say you were looking to make an offer on a house. Your lender suggests that the best mortgage for you would be a 30-year fixed mortgage. With 12 monthly payments a year, that would mean 360 monthly payments.
To make the math more straightforward in this example, let's say the offer you make is for $400,000, and you're putting down 10% or $40,000. To buy the house, you'll need to borrow $360,000
Now let's say that the $360,000 mortgage is not amortized. Each of the 360 monthly would consist of $1,000 in principal paydown, plus interest charged on the balance. Because the principal would decrease by $1000 after every payment, your interest will change every month.
- Your first month's payment will include interest on the entire $360,000.
- For your second month, you'd pay interest on $359,000.
- For your third, it would be $358,000, and so on.
As you can work out, you'll have much larger payments at the beginning of your mortgage repayment, which you might not be able to afford. Compare that to the halfway point, when you'll be paying interest on just half the initial amount, or $180,000. When your monthly payment is constantly adjusting from month to month, it's hard to budget for the rest of life's expenses.
Uncertainty fixed with amortization
Amortization accommodates this by setting a fixed recurring monthly payment amount for the life of the loan, even though you'll be paying off the loan's interest and principal in different amounts each month. As we mentioned, interest costs are at their highest early on. But over time, funds that go towards your principal increase while funds going to interest get less and less.
In a nutshell, amortization helps keep a borrower's monthly mortgage payment the same throughout the life of the loan so they can plan around a set payment structure.
Amortization gives you more buying power
Amortization seems complex, but it has a definitive effect on your ability to get financing to buy your dream home.
First of all, by having a fixed, recurring payment, your loan officer can better determine if you'll be able to handle that payment given your current credit rating and income. If the monthly payments are all over the map, he or she might lose confidence that you'll make payments on time. You might be considered more of a risk, and you might not get pre-approved. Remember, home sellers love a pre-approved offer. Pre-approvals go a long way in helping your offers stand out from the rest.
Since amortization makes your monthly payments smaller than they would be if you paid off the principal equally throughout the loan, you can qualify to borrow more. That might open up your home search to larger homes, homes in better shape, or homes in better neighborhoods. In essence, amortization gives you more buying power.
Visualize your amortization
The easiest way to understand amortization is to check out an amortization table, a visual representation that lists each monthly loan payment and details how much goes to either the interest or the principal. If you have a mortgage, an amortization table was included in your loan documents. If you're still in the research process, you can find examples all over the internet.
Better yet, check out NerdWallet's mortgage amortization calculator. This nifty tool lets you enter the amount you want to borrow, the down payment you're looking to make, and a possible interest rate. It'll even take your location into account so it can factor in potential taxes. Then it spits out a breakdown of what your monthly mortgage will likely be and show what amortization might look like for your loan.
Talk to us
Connect with a local Movement Mortgage loan officer. He or she will see how much you may qualify to borrow and look at how your monthly mortgage payments could change based on amortization and a 30 year or 15-year term.
