What is Mortgage Amortization and How Does it Work?

Paying off a mortgage is an overwhelming task.

A mortgage is a big debt—almost as big as your house—so the best most of us can hope to do is to shorten the term by prepaying as much of the loan that we can as quickly as we’re able.

Why should we want to do that?

Owning your home free and clear is a good place to be.  You’re living in your home with no mortgage payment and that’s when saving money and life in general get easier.

But there’s something more.

The cumulative interest on mortgage loans makes your loan balance even bigger.

A mortgage of $200,000 will require nearly $350,000 in monthly payments over a 30 year period.  Anything you can do to shorten the term can save a lot of money.

What is Mortgage Amortization?

Amortization—the built in payoff calculation contained in most mortgages—is your best tool in the process of getting your loan paid off.  Amortization, simply put, is the difference between your monthly mortgage payment and the interest portion it contains.

By making prepayments on your mortgage, either by increased monthly payments or by periodic lump sum payments, you decrease the amount you owe AND the monthly interest payment.  As the interest portion of your payment declines, the principal portion increases, and with it, the remaining term of the loan gets shorter.

Paying off your loan in 20 years instead of 30 will save nearly $120,000 in payments (based on a $200,000 loan), freeing up money for investing or for what ever else you want to do.

The Good and Bad News on Amortization

The good news on amortization is that it offers a guaranteed way to pay off your mortgage.

Even if you make no extra payments, because of amortization, you’ll own your home free and clear by the end of the loan term.  In addition, with each payment that you make, your equity will grow just a little bit.

During the “interest only” frenzy of a few years ago, this concept seemed to get lost in the all consuming drive for lower monthly payments.

The bad news is that amortization is slow–very slow!  

Like snail slow.

Like, ‘I paid how much towards my mortgage but the principle only went down that much?!?‘ slow.

Because interest is front-loaded on a mortgage (most of the interest is paid in the early years, most of the principal is paid in the later years), it will be many years into your mortgage before you’ll start seeing any meaningful decline in your loan balance.

By making prepayments you can accelerate the amortization process, enabling you to pay your mortgage off early.

An Example of How Mortgage Amortization Works

The best way to see how mortgage amortization works in real life is with an example.

Let’s assume you take a 30 year fixed rate loan of $200,000 with an interest rate of 4.00%, how will that look at different intervals?

Beginning of loan, first payment:

Monthly payment: $954.83
Principal portion: $288.16
Interest portion: $666.67
Remaining loan balance: $199,712

After five years, payment number 61:

Monthly payment: $954.83
Principal portion: $351.85
Interest portion: $602.98
Remaining loan balance: $180,543

After ten years, payment number 121:

Monthly payment: $954.83
Principal portion: $429.60
Interest portion: $525.23
Remaining loan balance: $157,139

As you can see from this example, about 70% of the first payment is interest—you’re hardly making a dent in the principal balance.  In fact, you’ll have paid off less than $3,500 in principal during the first year of the loan.

After five years, your principal portion has only increased by about $64 per month and you still owe 90% of the original loan amount!

You’ll have to hit payment number 153—12 years and nine months into the mortgage—before the principal portion of your payment first edges out the interest portion!

And at that point, nearly 13 years into the loan, you’ll still owe a balance of $142,608, or more than 70% of the original loan balance.  And you’re nearly halfway through the loan term!

Moral of the amortization story: amortization is a slow process, which is why it’s so important to begin prepaying your mortgage as early in the term as possible.

Try playing around with a mortgage calculator to see how much money you can save by accelerating the amortization process with extra payments.

A little each month or a lump sum here and there can make a big difference.

How Amortization Can Work Against You if You Refinance

As you can see from the example above, amortization works its magic very slowly over a long period of time.

Because of this, you have to consider the impact that a refinance will have on your efforts to one day own your home mortgage-free.

One of the primary reasons people refinance is to lower their monthly payment.

Getting a lower interest rate is one way to do this, but another is to lengthen the term of your new loan.

If you’re ten years into a 30 year loan, and you refinance back to another 30 year loan, your new payment will be lower, but you’ll achieve that by starting the amortization process all over again.

The best course—if you want to keep yourself on the original payoff schedule—is to set the term of the new loan to no more than the number of years you have remaining on the old loan, or in this case 20 years.

If you’re seven years into a 30 year loan, a refinance should be limited to 23 years—the same number you have to go on your current mortgage.

The recasting of loan terms back to 30 years was one of the biggest reasons why so many people watched their equity evaporate during the housing meltdown.

If you keep recasting your mortgage back to 30 years, your amortization will remain stuck in slow motion robbing you of the best chance you have to payoff your mortgage.  Think about this the next time you decide to refinance.

Finally

Amortization is something of an strange term, but you don’t have to shy away from it.  What it basically means is your loan was set up in a way that will take a specific amount of time to repay it.  As you go along, some of your payment goes to the interest and some to the principle.  How much goes to each will change over time.

With mortgage amortization you pay a lot more interest in the beginning than principle.  Keep this in mind if you ever want to refinance since you’ll have a new amortization schedule.

Also, realize that the quicker you can start paying more toward your principle, the quicker you build up your equity and you pay off your loan faster too.

Mortgage amortization can help and hurt you, depending on how you use it.