Key Takeaways
- Amortization splits payments into principal and interest portions over time.
- Early payments mostly cover interest, later payments reduce principal.
- An amortization schedule shows how each payment affects your loan balance.
- Understanding amortization helps you see how your loan is paid off over time.
Article Summary
Amortization is the process of paying off a debt, such as a mortgage, in regular installments over a period where each payment is divided into principal and interest portions.
Amortization: Explained in Plain English
Amortization refers to gradually reducing a loan balance through regular payments over a specified term, such as 30 years or 15 years.
Mortgage payments are divided between principal and interest, determined at the time the loan agreement is signed. An amortization schedule shows how each payment reduces the loan and how much is applied to interest.
For example, if you take out a 30-year FHA mortgage to buy a home, your amortization schedule will list all 360 payments. It will show how much of each payment goes toward reducing your loan balance and how much covers interest.
Over time, a larger portion of each mortgage payment is applied to the principal, reducing the loan balance, while the amount applied to interest decreases.
Amortization: A Real World Example
Consider a home buyer who takes out a $300,000, 30-year fixed-rate mortgage at 6% interest. Their monthly payment is about $1,799.
In the first month, roughly $1,500 of that payment goes toward interest, with about $300 going to principal and reducing the loan balance. Every month thereafter, as the homeowner makes payments, the amount still owed on mortgage decreases.
After approximately 20 years, and the numbers flip. More than half of each monthly payment now reduces the loan balance, with less going toward interest. By the final year, nearly the entire payment applies to principal, paying off the mortgage in full.
This shift over time is the essence of amortization: early payments cover the cost of borrowing, while later payments build equity more quickly.
Questions Home Buyers Ask About Amortization
Get answers to frequently asked questions about mortgage amortization, payment schedules, and loan balance reduction.
How does amortization affect mortgage payments?
In the early years of a mortgage, most of each payment is applied to interest. As time goes on, more of each payment is applied to reducing the loan balance (principal).
Can amortization schedules vary?
Most mortgages have a fixed amortization schedule. However, some loans with adjustable rates can change how much is allocated to principal and interest over time.
What is negative amortization?
Negative amortization occurs when payments are not enough to cover the interest, causing the loan balance to grow. Mortgages with negative amortization, such as Option ARMs, were largely discontinued in 2014 under Consumer Financial Protection Bureau guidelines.
