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Understanding Mortgage Amortization

Buying a home is often considered a foundation of wealth, and your mortgage amortization schedule provides a benchmark for how much housing wealth you are building as you make monthly payments of principal and interest.

When you make a monthly payment on a mortgage, you are reducing the balance of your mortgage. At first you pay more interest than principal, but as you pay down the balance of your loan, eventually you are paying more toward the principal.

Understanding mortgage amortization can help you develop strategies to pay your loan off faster, or avoid making refinance mistakes that could cost you thousands of dollars over the life of your loan.

We’ll take a deep dive into all the benefits of understanding mortgage amortization.

What is mortgage amortization?

Amortization means paying off a loan with regular payments so that the amount you owe goes down with each payment.

However, the thing about amortized debts like a mortgage is that while your monthly payment never changes, the share of that payment that goes toward the actual principal balance of your loan and the interest you owe the lender does.

Principal is the amount you borrow when you close on your loan. If you borrow $200,000 to buy a home, that is considered your principal balance.

However, mortgage lenders don’t make the bulk of their money by lending just principal — they make their living from the interest you pay for as long as you have your mortgage.

In the beginning, you’ll pay the least amount toward your principal while most of your payment goes toward interest fees. In fact, it may take a decade or more before you start making a bigger dent in your principal balance than you do in interest.

Mortgage payment calculators make it easy to visualize how the concept works. Using the LendingTree mortgage payment calculator, we took a look at the mortgage amortization on a $200,000 30-year fixed loan at a rate of 4.375%.

As you can see, this borrower pays more interest at the beginning of the loan and less at the end — only 27% of their monthly payment actually reduces their loan principal with their first payment.

It’s a much different story by the time the borrower reaches the end of their 30-year repayment term. At this point, the opposite story emerges — the lion’s share of the mortgage payment is going toward the principal loan balance.

That’s the heart of mortgage amortization — the monthly interest you pay is directly related to the balance of your loan.

First five years versus last five years of total principal and interest paid for $200,000 30-year fixed loan amount at 4.375% rate.

Payment years Total principal paid Total interest paid
1-5 $18,031.90 $41,882.33
26-30 $53,726.35 $6187.88

 

One other important thing to note: despite the change in how much principal and interest is paid, with a fixed rate mortgage, your payment never changes. Look at the first six payments on the $200,000 loan below:

Payment month Principal Interest Total principal and interest (P & I)
1 $269.40 $729.17 $998.57
2 $270.39 $728.18 $998.57
3 $271.37 $727.20 $998.57
4 $272.36 $726.21 $998.57
5 $273.35 $725.22 $998.57
6 $274.35 $724.22 $998.57

Despite the monthly change in how much is applied to the principal and interest, the monthly payment remains the same. As the balance drops, more of your payment is applied to principal, and less interest is due from the remaining balance.

5 reasons you should understand mortgage amortization

Once you’ve purchased a home, you can leverage knowledge of how mortgage amortization works to accomplish financial goals. Here are a few worth considering.

#1 Build equity in your home faster

#2 Determine when mortgage insurance can be canceled

#3 Make an educated guess about your mortgage interest tax write off next year

#4 Analyze the benefit of refinancing to a lower term

#5 Remind you of when you’ll need to do something about your adjustable-rate mortgage

#1 Build equity in your home faster

Once you become a homeowner you’ll be inundated with advertising about enrolling in bi-weekly mortgage programs, or pop-up ads that promise you insider knowledge from financial gurus about magical ways to pay your mortgage off faster. However, you hold the keys to all of this knowledge on a document buried in the middle your closing papers called an amortization schedule.

You don’t need to pay a monthly fee or take a seminar to see how mortgage amortization works — just find your amortization schedule and take a look at it. It will show you month by month how much your loan balance is dropping, and how much home equity you are building.

Home equity is the difference between your home’s value and your loan balance, and your amortization schedule shows you exactly how much your principal drops with every monthly payment. You can alter the course of that schedule by making extra payments — even one extra payment every year could shave five years off the total amount you pay.

Try an “extra payment” mortgage calculator to play around with different options for applying a little, or a lot of extra principal to your monthly payment to see how much equity you can build.

The graphs below show you one of the more popular ways to pay off your mortgage faster, and save thousands of dollars in interest.

Bi-weekly payments

One easy way to see how mortgage amortization works is to look at a bi-weekly payment schedule versus a normal one. Below we’ve provided a comparison of the first five years of payments on a regular $200,000 30-year fixed payment schedule and a bi-weekly payment schedule.

Notice that just in the first five years, you’ve got an extra $6,979 in equity versus the regular payment schedule. Bi-weekly payments amount to basically one extra payment a year, but have a significant effect on how fast you pay your loan off.

Regular amortization schedule vs. making bi-weekly payments for the first five years

Payment year Regular 

Principal paid

Bi-weekly principal paid Regular

Interest paid

Bi-weekly interest paid
1 $3298.47 $4491.65 $8684.38 $8989.05
2 $3445.70 $4522.33 $8537.14 $8459.09
3 $3599.51 $4724.40 $8383.33 $8257.02
4 $3760.19 $4935.50 $8222.66 $8045.92
5 $3928.03 $5156.03 $8054.81 $7825.39
Totals  $18,031.90 $23,829.91 $41,882.32 $41,576.47
Total extra principal paid down $5,798.01  Total interest saved: $305.85

The impact is even more pronounced if you look at the total interest you save over the life of the loan. Using the lending tree mortgage calculator, here are the results of bi-weekly payments over 30-years:

If you stay in your current home making bi-weekly payments, you’ll end up paying off your loan in just over 25 years, and save over $26,000. That’s just one example of how you can use mortgage amortization to build wealth and equity faster.

#2 Determine when mortgage insurance can be canceled

If you didn’t have the resources to make a 20% down payment when you bought your home, chances are you’re paying mortgage insurance as part of each monthly payment. With a conventional mortgage, you pay private mortgage insurance (PMI), which can be canceled when you’ve paid your mortgage down to 78% of the value of your home when you purchased it.

You can use your amortization schedule to determine how many years and months it will be before you can make the call to your mortgage company to have them remove PMI from your mortgage payment — forever. First you need to know roughly what the balance would be based on 78% of your original balance.

If you bought a $250,000 house with a 10% down payment, your principal loan amount would be $225,000. To figure out your PMI cancellation point, you’d multiply $250,000 x .78 — so for a $250,000 loan your loan balance would need be $195,000 for PMI cancelation.

Using an amortization schedule can help you pinpoint when the balance will get to $195,000:

Payment year End of year loan balance
1 $221,278,23
2 $217,412.81
3 $213.363.36
4 $209,133.15
5 $204,714.11
6 $200,097.81
7 $195,275.45
8 $190,237.84

 

Based on the yearly amortization chart, the balance will drop to a point where PMI can be canceled somewhere between year seven and eight. If we open up the monthly amortization schedule we can pinpoint the year and month more precisely.

Opening up the year eight monthly payment schedule, the balance drops below $195,000 after your January payment. It may be years in the future, but knowing the date will ensure you aren’t paying PMI you no longer need.

Year 8 monthly payment schedule End of month loan balance
January $194,864.00
February $194,451.05
March $194,036.60
April $193,620.63
May $193,203.15
June $192,784.14

 

#3 Make an educated guess about your mortgage interest tax write off next year

One of the tax benefits of owning a home with a mortgage versus renting is the potential to use mortgage interest to reduce your tax liability. Because you pay more in interest at the beginning of the loan, you may want to bring your amortization schedule to your tax preparer in the early years of homeownership to see if it makes sense to make any adjustments to your tax withholding.

Why give the government an interest free loan this year by having more taxes withheld than you need to now that you’re a homeowner? Or you can keep your paycheck the same, and use any tax refund to pay down your loan faster.

#4 Analyze the benefit of refinancing to a lower term

Many people just look at the monthly savings when they are refinancing, and if the monthly savings isn’t high enough, they may opt out of refinancing. However, it’s always a good idea to compare the amortization schedules for your current loan and the refinance loan to see how much that lower payment could affect the total interest you pay over the life of a loan.

If you’re living in your “forever” home, even a 0.5% reduction in rate could save you thousands of dollars over the life of your loan.

Refinancing to a shorter term, like a 15-year fixed mortgage is often hard to conceptualize, until you see just how much more of your payment is going toward your principal, and how much less interest you are paying every year. Seeing this may help soften the initial sticker shock of the higher monthly payment that comes with paying off your loan on a shorter fixed payment schedule.

Another way to build your home equity faster is to shorten the term of your mortgage. You’ll have to be able to afford the higher payment, but the comparisons below show how much less interest you’ll pay over the life by reducing the term.

30 year total lifetime interest vs. 15 year fixed

The benefit of paying an extra $469 per month for a 15-year fixed amortization saves you $95,447.16 in total interest, and you have a mortgage-free home in 15 years.

#5 Remind you of when you’ll need to do something about your adjustable-rate mortgage

If you decided to borrow using a adjustable-rate mortgage (ARM) to save some extra money for a short period, you’ll want to take a look at what happens to your principal and interest payments after the initial fixed rate period ends. ARM loans can be great tools to get a lower payment for a set period of time, but you should know what happens when that initial rate changes.

Your amortization schedule will show the year and month when that change could kick in, and a calendar reminder a few months before will keep you from forgetting to pay attention in the mail to see how much your payment is going to change.

The example below shows what happens to your amortization schedule between your 60th and 100th payment on a $200,000 5/1 adjustable rate mortgage with 2/2/5 caps and an initial rate of 3.5%. That means your rate is fixed for the first 5 years, and the first adjustment can increase your rate up to 2% every year, and your maximum rate can’t be more than 5% above where you started.

After the fifth year (60th payment), not only does the payment go up, the amortization schedule changes, and as the rate rises you are paying much more interest than principal. This is why most lenders recommend that you only obtain an ARM if you plan to sell or can refinance before the initial adjustment period.

Adjustable Rate Payment Month Rate Principal Interest
1 3.5% $320.54 $594.07
60 3.5% $380.64 $533.97
61 5.5% $284.56 $837.35
73 6% $279.51 $895.96
86 6.5% $278.12 $950.45
97 7% $275.88 $1005.23

 

What you need to know about interest-only and negative amortization loans

Some home loans do not require amortization, or allow you to defer paying principal for a set period of time. There are also loans that actually feature “negative amortization,” meaning the loan balance grows each month instead of shrinking.

It’s very important to understand how the loans work so that you don’t end up losing your home to a foreclosure.

Interest-only loans

Just like the name implies, an interest only mortgage doesn’t require you to pay principal for a set period of time. The most common example of a loan that often has an interest-only option is a home equity line of credit (HELOC).

This type of mortgage works much like a credit card, allowing you to charge the balance and pay if off as often as you wish during a set time called a “draw period.” Your monthly payment is very low because it’s only based on interest charges on the amount you charge, and the draw period usually lasts 10 years.

However, mortgage amortization kicks in after the 10-year draw period is up. That means any balance that is still on the HELOC after 10 year will have to be paid based on a pre-set amortization schedule.

Interest only payments do not reduce the principal (HELOC). After the draw period, the remaining balance usually pays off at a shorter term of 10 to 20 years.

Negative amortizing mortgage loans

A negative amortizing loan works in the reverse of how a regular amortizing loan works — the lender gives you the option to pay less than the interest that is accruing each month, and the balance of the loan grows. Negative amortizing loans were prevalent before the housing crisis of 2008, but current laws make them very rare.

However, there is one type of negative amortizing mortgage that still exists — the reverse mortgage. Reverse mortgages are only available to borrowers 62-years and older, and the maximum amount that can be borrower compared to the home’s value is much lower than a regular “forward” loan.

Eligible seniors can take out equity based on their age with very little income qualifying requirements and no credit requirement. Money can be drawn in a lump sum, as monthly income, or taken out as a credit line — or a combination of all of these.

It’s very important that you review the amortization schedule on a reverse mortgage to determine how much the balance increases monthly with each type of “draw” that is made. There is no monthly payment required on a reverse mortgage and interest charges accrue each month on top of the principal that is taken out.

The example below shows what happens to a if you borrow a lump sum of $100,000 with a reverse mortgage and an accruing interest rate of 5%. Even though the money goes to you as a lump sum, the lender charges interest on the money, which gets added to your principal balance instead of subtracted, as it would when you make a payment on a normal amortizing loan.

Reverse Mortgage Year  Principal Balance
1 $105,000
5 $127,628
10 $162,889
25 $338,635

By the 25th year, the balance of the loan has nearly tripled to $338,635 — just for a $100,000 initial loan. If you take this loan out when you’re 62 years old, by the time you are 87 years old, you’ve reduced the equity in your home by $238,635.

The government HECM (home equity conversion mortgage) program has strict requirements for third party counseling from a government-approved housing counselor to keep seniors from being taken advantage of, but there are proprietary reverse mortgage programs that don’t have the same protections.

Be sure you thoroughly review the amortization schedule on any reverse mortgage you are offered. If you have an elderly relative who is considering one, it’s wise to suggest an extra set of eyes on the terms they are offered as well as how the loan amortizes over time.

Tips to pay down your mortgage faster

One of the big things that stands out once you understand your mortgage amortization table is just how much you’re spending on interest.

When you see that almost 70% of your initial monthly payment is going toward interest, and when your total interest cost is almost as much as your original mortgage amount, it’s natural to start thinking about what you can do to reduce those interest costs and save yourself some money.

There are some simple ways to reduce the amount you pay in mortgage interest, but most experts suggest first taking a step back and questioning whether doing so is truly in your best interest.

Consider paying off higher-interest debts before putting extra money towards your mortgage. Paying off a credit card that charges 15% or 20% APR will usually save you more money than directing extra payments to your mortgage with a 4.5% APR, for example.

That being said, if you don’t have high-interest debt and you’re already on track for your other financial goals, putting extra cash towards your mortgage can both save you money and provide some peace of mind.

Here are a few ways to do it:

  • Refinance: Refinancing to get a lower interest rate could be more effective than simply paying extra each month. A lower rate means more of your payment goes towards principal, which speeds up the repayment process. You can use LendingTree’s refinance breakeven calculator to determine if refinancing makes sense.
  • Make a bigger down payment: If you’re taking out a new mortgage, a bigger down payment reduces the loan amount and often reduces your interest rate as well.
  • Make bi-weekly payments: We touched on this in the example earlier, but making bi-weekly payments (every other week) effectively result in 13 monthly payments per year, leading to a shorter repayment period. Just be wary of companies that try to charge a fee or prepayment penalties — you can do this on your own at no cost.
  • Increase your monthly payment: Consistently paying more than your required monthly payment will put more than expected towards your principal each month, which will reduce your balance and save you interest charges. Just keep in mind you’ll need to work up a new amortization schedule to see how the extra payment affects the interest you pay over the long haul.
  • Pay extra money when you can: Any time you receive extra money — like a tax refund, bonus or gift money — use some of it to make an extra payment towards your mortgage. The LendingTree mortgage calculator gives you the option to recalculate your amortization schedule after using one of these “cash bombs” to pay down your balance.
  • Recast your loan: If you come in to a significant amount of money, your lender may also give you the option to recast your mortgage. A recast allows the principal and interest payment schedule to be changed to reflect the new loan balance at your current interest rate, resulting in a lower payment and less interest paid over the life of the loan. Lenders may charge a fee of around $200 to $300 to complete a recast, but it may be worth it if you have at least $5,000 to $10,000 to pay down your loan balance.

Final thoughts

The ultimate goal with any type of loan should be to pay it off as soon as possible. This frees up the full value of the property, and gives you free and clear shelter for yourself, your family, and potential generations of your family.

Understanding mortgage amortization can help you keep an eye on how much equity you’re building, and develop strategies to pay your loan off faster so you can allocate the money towards something other than mortgage interest for 30 years.

The amount of interest you pay depends on the interest rate you were approved for, and hopefully shopped for the best mortgage rate possible. The better the interest rate, the less interest you pay over the life of the loan, and the lower your payment is.

-Matt Becker contributed to this article

 

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