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A Guide to Mortgage Amortization for Beginners

5-minute read

As soon as you start making payments on your mortgage, your loan will start to mature using a process called amortization. But how exactly does amortization work? We’ll take an in-depth look at what amortization is and how it helps you reach your ultimate goal of paying off your mortgage.

What Is Mortgage Amortization?

Mortgage amortization simply means that you pay your home loan on a fixed repayment schedule over a set amount of time. Lenders use a tool called an amortization schedule to show you in detail how each periodic payment on an amortizing loan will ultimately end with your complete loan repayment.

How Does Amortization Work?

In a nutshell, amortization works when you make payments on your loan's interest and principal in amounts that vary over time. Most of your money goes toward interest during the first years of your loan. As your loan matures, more of your payment goes toward principal and less of it goes toward interest.

This doesn’t mean that your mortgage payments get smaller as time goes on – amortization schedules are structured so that you pay the same amount each month. In other words, the principal and interest are just distributed differently as time goes on.

Check out the amortization calculator from Quicken Loans® if you’re curious to see your full amortization schedule and analyze how your payment allocations will change over time. You can plug in the loan amount and interest rate that pertains to your mortgage. The calculator can also show you how much you can save by making additional principal payments on your mortgage.

Principal And Interest

Understanding the difference between principal and interest is a critical part of understanding amortization.

Principal

The principal is the part of your loan balance that you owe to your lender. Another way to think of it is that it’s the total loan amount borrowed from your lender, excluding interest. You’ll get an official document called a Closing Disclosure before you close on your mortgage which will tell you your exact loan amount, or principal.

Interest

Interest is a fee that your lender charges you to borrow money for a specific length of time. The amount of interest you owe depends on your interest rate and the loan amount – the lower your interest rate, the less you owe in interest.

The interest is calculated off the principal balance of your loan, so as the principal goes down during the life of the loan, so will the interest.

Your loan might have a fixed interest rate that’s the same every month or you might have an adjustable rate that changes with the market. Either way, your Closing Disclosure will tell you what percentage you’ll pay in interest. Your lender expresses your interest rate annually, not monthly. For example, if you have a 4% interest rate, you don’t pay 4% every month. Instead, that 4% splits between each of the 12 months.

You only pay interest on the principal that’s left on your loan. Every dollar that you use to pay off your principal is a dollar that stops accruing interest. That’s why even very small extra payments can drastically reduce your loan over time.

Can You Make Extra Payments To Your Mortgage?

Most lenders allow you to make extra payments to your loan as often as you like. Extra principal payments can be a powerful tool when it comes to reducing your mortgage because extra payments reduce your principal, meaning that you own more of your home. The percentage of your home that you own is called equity.

Be aware that some mortgage lenders limit over-payment to maximize the amount of interest you pay. Check to see if your loan includes a prepayment penalty before you make a large extra payment. A prepayment penalty is a fee charged by a lender if you pay off your mortgage too quickly.

Prepayment penalties vary by lender. Make sure you fully read the terms of your mortgage before you sign, especially if you plan on making large extra payments on your loan. Rocket Mortgage® by Quicken Loans® does not have any prepayment penalties.

Mortgage Amortization Example

Even if you understand what amortization is, it can be complicated to think about it in terms of dollars and cents. Let’s work through an example to illustrate the amortization process.

Let’s say you take out a 30-year mortgage with a $200,000 principal and a fixed 4% interest rate. Your lender tells you that your monthly payment is $954.83 before taxes and insurance, but where does that money actually go? In the first month, your payment goes almost entirely toward interest: $665.71 goes toward interest and only $288.16 goes toward principal.

Every month, this process repeats itself and you pay less and less toward interest. By the time you pay off the loan, you will have paid your original $200,000 loan as well as $143,738.99 in interest.

Making extra payments on your loan drastically reduces the amount of interest you pay. When you make an extra payment, the balance goes directly toward your principal. Let’s take a look at how much just a tiny extra payment each month can shorten the life of your loan.

Let’s say that you take out the same 30-year fixed rate loan worth $200,000 with 4% interest annually. Your monthly payment is still $954.83, but let’s say you pay an extra $100 per month toward principal. At the end of your loan, you will have saved $26,854.95 in interest. That’s 59 months of payments saved!

Depreciation And Amortization: What’s The Difference?

You might come across another term when you’re learning more about mortgages: depreciation. Depreciation and amortization are often confused with one another but are actually two completely separate concepts.

Depreciation is a term that refers to an asset that loses value over time. If your property depreciates in value, it means that it’s worth less than when you bought it. In the context of real estate, the word depreciation typically refers to rental properties that a landlord can only rent out over a certain number of years. For example, if a landlord buys a property for $300,000 that he or she can rent out for 30 years, the property would lose $10,000 worth of value each year as it ages.

Depreciation only applies to the property itself, while amortization only applies to your loan. By its nature, a loan cannot depreciate in value. Loans don’t lose their value when you pay them off – the lender simply gets his or her money back. In the same way, a property itself cannot amortize. 

You may also hear someone refer to a business asset amortizing. The term amortization can also apply to intangible assets, like a license or certificate that loses value over time. However, this is a totally different definition of the word amortization. It's not related to the amortization of a mortgage.

Summary

Amortization is the process of paying your home loan over a fixed number of years. Every mortgage payment includes two parts: principal and interest. The principal is the part of your loan balance that you owe to your lender or the total loan amount borrowed from your lender, excluding interest. Interest is a fee that your lender charges you to borrow money for a specific length of time. The amount of interest you owe depends on your interest rate and the loan amount – the lower your interest rate, the less you owe in interest.

Your Closing Disclosure includes information on both your principal and your interest rate. When you start paying your loan, most of your monthly payment goes toward interest. As time goes on and your amortization schedule progresses, your principal gets smaller and smaller. That means that you pay less in interest near the end of your loan.

You can pay more than your required monthly mortgage payment toward principal. These payments can drastically reduce the amount of money left on your loan. As you build equity in your home, your principal accrues less and less interest and more of your money goes toward paying off your principal balance. Even a small extra monthly payment can save you thousands of dollars in interest down the road.

Some mortgage providers limit how much you can overpay with a prepayment penalty. If your loan includes a prepayment penalty, you may have to pay a fee. Prepayment penalties vary by lender, which is why it’s so important to read and understand all the terms of your loan.  

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