Amortization is the process that American mortgage loans use for payments. Basically, each month you pay interest based on the principal that is outstanding for that month, plus a little bit of money toward the principal itself. That means next month there is a little bit less principal, therefore a little bit less interest accumulating. You are still charged the same loan payment as before, but this time since the interest is a little bit less, a little bit more of the payment is applied to the interest. Progressively more of each payment goes to reducing the principal and progressively less of each payment is going to the lender in interest charges. This means payments for new loans are almost all interest, while payments for old loans are mostly principal, actively decreasing the loan total instead of just paying the lender for the loan. The closer you get to paying off your loan, the less money the lender makes off of you each payment and the more money each payment you get to “keep” as equity: the part of the home that is paid for and the value that belongs to you alone.
This is a key concept of the American mortgage, and it can work in a few different ways. A fixed rate mortgage (for any length) has a fixed payment which is calculated and set at the signing of the loan. Additional principal payments to a fixed-rate loan will ultimately reduce the term of the loan (the amount of time it takes to pay it off), for instance, bringing a 30-year fixed rate loan to pay off several years earlier. Even if you used a financial windfall to significantly reduce the principle (such as a $50,000 inheritance cutting the $100,000 loan in half), the payment will remain the same, you’ll just reach pay-off day a lot faster. Nothing short of a total refinancing will change the payment amount of a fixed rate loan.
Fixed rates do, however, actively support early pay-offs in this fashion. Since reducing the principle reduces interest payment amounts in each following month, making frequent extra principal payments, or a single large principal payment, can cause the ratio of principal to interest in each regular monthly payment to ‘snowball’ – rapidly increasing the principle side of the equation and speeding toward early pay-off. This is a great thing for long-term homeowners seeking to own their home outright, or those working to rapidly build equity for financial reasons (such as to get rid of costly mortgage insurance).
Variable rate loans or adjustable rate mortgages (ARMs) are the opposite. Variable rate loans are regularly recalculated for the length of the term; the rate is being reassessed and the payments are reformatted to reflect the current rate for the remaining principal over the time remaining on the term agreement. Additional principal payments therefore can significantly reduce the payment, not the term. Variable rates support decreasing the monthly payment, but are pretty hard to pay off early. It can be done, but it takes some planning around the rate adjustments and is most easily accomplished with a complete lump-sum payoff made with the support of the lender.
Borrowers can use amortization to their best advantage. Understanding how amortization affects your loan can help you decide if and how additional principal payments might benefit you. The following calculators from the website The Mortgage Professor are great tools to help you see the difference amortization can make for you: fixed rate mortgage extra payment calculators and variable rate mortgage extra payment calculator (*note, this one is a lot more complicated!). Your lender can also (and probably much more easily) calculate these changes and help you understand how extra principal payments will affect your loan term or monthly payment.
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About The Author: Geoffrey Thompson is an owner and founding partner of Colibri Real Estate, LLC. Since 1996 the companies under this banner have offered online real estate licensing and insurance licensing courses as well as online real estate exam prep and insurance exam prep.
