Amortization: What is it and how does it work?

Amortization is the process through which your monthly loan payments reduce your loan’s principal, eventually paying the loan off. Each payment helps to amortize the loan by paying all of the interest that accrued that month, plus a portion of the loan’s principal.

Interest is calculated based on the loan’s principal balance. That means that at first, more interest accrues, so a greater portion of your payments goes toward interest. As time passes and the principal decreases, less interest accrues, so more of each payment goes toward the loan’s principal, accelerating the speed at which you pay it off.

By following the amortization schedule of your loan, the timeline that shows how the loan balances reduce until it’s paid off, you can see how your payment is split between principal and interest over time. This article will break down what you need to know about mortgage amortization and why it’s important. You can use this amortization calculator to look at different possible loan amortization schedules or see an amortization schedule for your current loan.

Amortization definition

In terms of mortgages, amortization is the process of gradually paying down the loan balance through regular monthly payments. These payments include both principal and interest until the loan is fully paid off.

Mortgages are usually for 15-year or 30-year terms, though some loans have other terms, such as a 20-year term. The term of your mortgage affects how long it takes to fully amortize the loan and the total amount of interest paid.

There are many different types of mortgages. These include FHA loans, VA loans, Jumbo loans, and many others. It’s good to consider these different loans and how they can benefit you when choosing what kind of mortgage works best for you.

You may have also heard of amortization in the world of accounting. When it comes to accounting, amortization refers to spreading the cost of an intangible asset, like a software license, over its useful life. It’s similar to the depreciation of tangible assets.

How does amortization work?

Mortgage amortization reduces the balance of your loan over time. Precisely how it works depends on the type of mortgage you have. You can use a mortgage amortization schedule to see how much your loan principal is reduced each month.

Fixed-rate mortgages

With a fixed-rate mortgage, the interest rate of your loan is set when you receive the loan. It does not change at all throughout the life of the loan. This allows for predictable monthly payments, which can help with budgeting.

Generally, early payments go mostly toward covering accrued interest. Over time, the principal of the loan falls and less interest accrues, letting more of each payment go toward principal.

Adjustable-rate mortgages (ARMs)

Adjustable-rate mortgages (ARMs) have interest rates that can change during the loan’s term. The rate of the loan is usually fixed for an introductory period, such as five or seven years. After that period, the rate can adjust on a regular schedule based on a predetermined market index, such as the 10-year Treasury bond rate, plus a margin amount.

Usually, ARMs are described using numbers, such as a 5/1 or 7/1 ARM. A 5/1 ARM has a rate that is set for five years and then adjusts annually after that.

ARMs typically have lower introductory rates than fixed-rate loans, but they can be unpredictable. If rates rise, your payment could rise too. Though ARMs usually have minimum and maximum rates, if rates rise by too much, your loan could become unaffordable.

Like with a fixed-rate mortgage, early payments mostly cover interest, with more of each payment going toward principal over time.

Interest-only mortgage

An interest-only mortgage is an uncommon type of home loan that is not amortized with regular payments. It’s important to understand how mortgage interest works with this type of loan. Instead, each monthly payment only covers the accrued interest. Once the interest-only period ends, the borrower then has a few options for dealing with the principal of the loan:

• Pay the balance in full
• Refinance the loan
• Begin making normal principal and interest payments to start amortizing the loan

Balloon mortgages

A balloon mortgage is a type of nontraditional mortgage.

They typically have shorter terms than most mortgages, such as five years or ten years. Monthly payments are low but do not fully amortize the loan. Once the loan’s term ends, the loan will still have a principal balance, and the borrower will have to make a balloon payment to pay off the remainder of the loan.

The balloon payment at the end of the loan can be very large, so it’s important to make sure you have a plan to refinance the loan or are prepared to make the large payment.

Example of amortization

When you get a mortgage, you can calculate the amortization schedule of the loan. This is simple to do with fixed-rate loans because their rates won’t adjust during the life of the loan, but you can also calculate it for other types of mortgages. You just may need to adjust your calculations based on potential rate changes.

Imagine you get a 30-year mortgage for $200,000 at a rate of 6.5%. The table below shows the amortization schedule, including the payment amount, what portions of the payment go toward interest and principal, and what the loan’s remaining balance is.

Why it’s important to understand amortization

Understanding mortgage amortization is important because it’s the process through which you reduce your loan’s balance and build equity in your home. Paying down your mortgage faster helps it amortize more quickly, reducing interest costs and increasing your equity.

Consider the above example of a $200,000 loan at 6.5%. Paying an extra $200 per month helps reduce the loan’s principal more quickly, reducing the loan’s term to just under 21 years and saving you more than $90,000 in interest.

Knowing how amortization works can help you decide whether making extra payments is a good idea and help you determine how much those payments can save you. Be sure to review your loan’s terms carefully to make sure you understand whether you’ll have to pay any fees if you make extra payments, such as a prepayment penalty.

The bottom line: Understanding amortization can help you choose the right mortgage

Mortgage amortization is the process through which your payments reduce your loan’s principal, eventually paying it off. Understanding how amortization works and looking at your loan’s amortization schedule can help you determine whether making extra payments on your loan is worth doing or simply help you track your progress toward paying off the loan.

If you’re ready to start the homebuying process, you can apply for a loan with Rocket Mortgage^® today.