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What is Amortization?
Amortization is the act of paying back the balance of a loan with a set schedule of fixed, monthly payments.
Each payment includes two key components: principal and interest. At the beginning of making payments, your payments cover the interest more than the principal. Moreover, towards the end of your payments, your monthly payments are mainly principal.
Depreciation and amortization are terms people usually mix together.
As previously stated, amortization is a repayment plan with a set schedule of fixed payments and terms. On the flip side, depreciation is the loss of value over time. Amortization and depreciation really don't mesh at all.
Use our amortizing loan calculator to calculate your loan amount by entering your desired payment, or alternatively enter the loan amount and calculate your monthly payments.
Loan Amortization – How It Works
Loan amortization is the process of paying back a loan with a fixed rate and a set payment schedule over a period of time. Principal and interest are the two main components of an equal amount regarding loans.
Firstly, interest is what you start paying back on a loan. You pay the second component afterward.
Just to clarify, the principal is known as the second component of a loan.
Are the components equal?
The answer is no. The interest, which is a higher percentage, is the first part that you owe on the loan first. A small portion is used to pay off the balance. Incrementally, the two components are equal in weight. Over time, the principal payments become higher than what you pay on interest.
At the end of your loan term, the past payment consists of the principal.
Mortgage Amortization – How It Works
This type of amortization loan is what you use to purchase your property of choice.
Mortgages are usually long term; they have maturities over 20, 25, or even 30 years. Some people prefer shorter terms such as 20 or 25-year loan payment options.
In addition to, their payments are higher as they commit to a shorter term. The amortization period doesn't only determine your monthly payments, it also provides the overall interest of your balance. Long-term loan payments are lower than a short-term loan. On the flip side, the cost of the loan is significantly higher.
Each and every individual needs to consider which type of loan is better for his or her situation. The question is, are you willing to pay more to have a wider term period.
How Does Amortization Schedule work?
The amortization schedule plays a key role in an amortization loan.
Here is a table where the borrower can see key information:
- Each month
- The total payment
- The interest payment
- The principal payment
- The balance of the loan
Moreover, you can see that the borrower has to pay $2,148 to the lender. The amount doesn't change; this is the meaning of amortizing. You can also see the amount of the two portions doesn't change:
The interest portion is significantly higher than the principal. For example, of the amount $1,667, only $481 goes towards the principal. The principal portion increases and the interest portion decreases in the second month. This is how it is down to the last loan payment; paying the principal amount pays off the rest of the loan.
Many assume that an amortization schedule is 12 dates in a year; it’s actually 12 months. The exact day that follows the day, your mortgage closes. A month after, your first loan payment is on that exact same day as well. For example, if your loan closes on November 25, your account is active on the 26th. Your first payment will be due on the 26th as well.
Using an online mortgage calculator is essential to know an estimate of how much your loan costs.
Learn How To Calculate Amortization Schedule
In this section, I'm going to show you how to replicate an amortization schedule. This is going to help you understand the process better as you take out your loan. The following are four things you need to know: the monthly payment for the whole period, the term of the loan, the interest rate and the balance of the loan.
Let's say we have a $400,000 loan that's a 30-year term with a 5% interest rate. In addition to, your monthly payment is $2,148 through the whole term of the loan. Here are the steps you need to follow:
Multiply the balance of the loan by the periodic interest rate, which is 1/2 of 5%. Remembering there are 12 months in a year is very important. $400,000 times 0.00416 equals $1,667. This payment is the interest payment for the first month.
Next, subtract the interest payment from the monthly payment. $2,148 – $1,667= $481. The amount you see is the principal payment.
Moreover, the next step is to calculate the payments for the second month. First, subtract $481 from the balance of the loan. The number comes out to $399,519. Afterward, repeat step 1 and step 2 using the new balance; the result shows you how much you owe in interest and principal for the second month.
If you repeat steps one, two, and three for the rest of the loan term, you will have a good idea how amortization schedules are put together.
Mortgage Amortization Pros
One of the biggest advantages is that it is a fixed, monthly payment. This is a big deal because the borrower knows the payment isn't going to change expectantly. This option is very manageable.
Every borrower has their own individual amortization schedule that conforms to their ability to repay and financial status. Moreover, borrowers can temporarily get a flexible interest rate only for a certain amount of time. The client determines whether or not it's fixed or a variable rate.
As time progress, the interest payment will decrease. Eventually, the principal will also decrease; the interest payment will follow suit as well.
Mortgage Amortization Cons
One of the disadvantages is that you have to make larger payments to decrease the cost of the loan. Since most people can't afford to do this, they end up paying a higher interest rate; especially with a long-term loan.
Amortization mortgages don't have equity built on the front-end. This means that you have to pay the interest first before you pay the principal. At times, borrowers have a very low equity because their payments go towards interest first.
Refinancing And Mortgage Amortization
Refinancing is the process of getting a new loan that replaces the original one. People who usually want better terms choose to do this.
How does refinancing and mortgage amortization go hand in hand you may ask?
Let me explain. Mortgages are loans with very long terms. If you ever consider refinancing your loan, it will affect your amortization schedule.
People choose to refinance because they want cheaper monthly payments and a low-interest rate. In addition to, the bank has the right to extend the loan term without lowering the interest rate.
Here's an example:
A 25-year mortgage at 5% and you have been paying for 10 years. Let's make the conclusion that you want to reduce the monthly payments. The loan officer at the bank decides to refinance your loan using the same interest rate, but for 30 years. The process of amortization starts again with a brand new schedule. There is an option to keep your same schedule if you refinance the mortgage loan that's equivalent to the remaining years.
Overall, this is a big risk and can cause serious problems for you. Take into account that you already paid 5 years on a 30-year mortgage. At that point, the equity is very small. If you decide to refinance, you have no choice but to start back from square one. As a result, you pay more interest than the principal regarding payments.