What is mortgage amortization, and what does it mean to a home buyer and mortgage shopper? This is actually an important topic that confuses a lot of people. But when you start peeling away the layers, you’ll find that it’s not so complicated after all.
Let’s start with a quick definition. Amortization is defined as the paydown or reduction of a liability, such as a mortgage loan, in regular monthly payments over a specified period of time. The monthly payments are divided between the principal and interest of the loan.
As a part of the mortgage lending process, your lender will provide you with an amortization schedule that shows you the breakdown of your monthly payments. In other words, it shows how much goes to pay the interest, and how much will pay down the principal and the remaining balance until the loan is paid off. This schedule can be provided in a monthly or annual format.
As a home buyer, there are some things you need to understand about the amortization calculation or schedule you are given:
What to Know About Your Amortization Schedule
Mortgage loans amortize over time. Amortization is the gradual reduction in a debt when regular payments are made. As you make your monthly payments, your home loan will gradually amortize (or reduce) until it is fully paid off. Unless, of course, you refinance or sell the home before the loan’s term expires.
When a lender offers you a mortgage rate, they should also provide an amortization table that shows how your loan amortizes over time. During the early years of the term, most of your monthly payment will go toward the interest. So you don’t reduce your principal very quickly in the early years. But this changes over time. Toward the end of the loan’s term, most of the monthly payment will be applied to the principal. So you will pay down your principal more quickly in the later years. This is the typical pattern of amortization for home loans.
Watch Out for Negative Amortization
The first thing you want to watch out for is a negative amortization loan. This means that your monthly payment does not cover both principal and interest, so there would be a remaining balance at the end of your mortgage loan term. If the payment is not enough to cover the full amount of interest due, as well as the principal for each month, the remaining unpaid interest amount would be added onto the balance of the loan, again resulting in a balance at the end of your loan term.
Negative-amortization home loans were commonly used during the real estate boom of the 1990s and early 2000s. Many borrowers were initially unable to qualify for or afford the full payment amount on the size of loans they wanted. So the loans were structured in a way that reduced the payments initially, but led to an adjusted payment amount later on. This could present a real problem to a borrower if the negative amortization schedule was not fully disclosed, because at some point the loan payment is going to adjust in order to “correct” itself. And this could lead to a significant increase in the size of the payment.
No doubt, this can be a confusing subject. That’s why it helps to have a visual aid (the mortgage amortization schedule / table) as well as someone who can explain it to you. It’s critical that you understand this concept, so you don’t face any unpleasant surprises several years into the life of your loan.