1. Home
  2. Mortgages
  3. Mortgages
  4. What is amortization?

What is amortization?

For many borrowers, fixed monthly payments are the way to go

Author picture
Written by Jennifer Schurman
Edited by Cassidy McCants
accountant calculating interest

Mortgage amortization is a process by which your mortgage principal decreases over time as you make payments. While the payment amount remains fixed over the life of the loan, the portions that go toward principal and interest will differ with each payment. You’ll pay off the principal and build equity throughout the loan term.

How does an amortization schedule work?

With mortgage amortization, you pay back your home loan debt with fixed monthly payments that include both principal and interest. You’ll have an amortization schedule, which shows you exactly how much of each monthly payment is going toward the principal and how much is going toward interest.

For example, say you obtain a mortgage for $250,000 with a fixed interest rate of 3.73% (around the national average as of publishing) over 30 years. The first few months of the amortization schedule would look something like this:

chart depicting the first five month of the amortization schedule

Each payment remains fixed throughout the life of the loan, but a large portion of your early monthly payments goes toward interest rather than lowering your principal. With every month that passes, though, you pay off more and more principal. In the later years of the loan, you’ll pay off mostly principal.

In the first month, your total interest paid would be $777.08. By the fifth month, you would have paid $3,873.63 total in interest.

Here’s what the last five months of the amortization schedule would look like:

chart depicting the last five month of the amortization schedule

When you make the final payment in January 2052, your loan will be completely paid off. Your total interest paid by the end of the loan: $165,783.30.

Amortization vs. depreciation

Amortization is similar to depreciation (both reflect the reduction in the value of specific items), but the two terms have slightly different meanings. Amortization refers to how the value of an intangible item, like a mortgage, decreases over time.

Depreciation, on the other hand, refers to how a tangible asset (like a car) loses its value over the years. If you bought a car a few years back, it’s likely not worth as much now as it was when you first purchased it. You might have heard of businesses depreciating their assets and assigning expenses to these devaluations each year.

Calculating amortization

The general formula for calculating how much of your monthly payment is going toward principal and how much is going toward interest is:

Principal payment = monthly payment - interest due for the period

Going back to the example of the $250,000 loan at 3.73% for 30 years, let’s calculate the components of the third monthly payment. First, calculate the interest due for the month by multiplying the monthly interest rate (0.0373 divided by 12) by the remaining loan balance. 

Interest due for the period = remaining loan balance x (annual interest rate divided by 12)

If two months have passed, the remaining loan balance is $249,243.08. When you multiply this figure by the monthly interest rate, you get $774.73. This is how much interest will be due in your third monthly payment.

To calculate how much principal will be paid down, you subtract the interest from the fixed monthly payment. That’s $1,154.95 minus $774.73, which equals $380.22. The principal will be reduced, or paid down, by $380.22 with the third monthly payment.

Benefits of amortization

The amortization process is helpful for most borrowers because it allows for fixed, manageable monthly payments, but there are some downsides to this method of mortgage repayment — like the amount of interest you have to pay over time.

How it helps

  • Fixed payments: With mortgage amortization, your monthly payment doesn’t change over the course of the loan (with a fixed-rate loan). What does vary is how much of each payment is allocated to principal and to interest.
  • Builds equity each month: Mortgage amortization also allows the borrower to build equity with each monthly payment they make. As the principal is paid down, the homeowner increases their equity, or ownership, in the property.

What to consider

  • Higher interest costs with longer loan terms: With amortization, you aren’t paying off much of the principal in the beginning. Interest is calculated from the remaining balance, so your interest costs are pretty high until you start to make a dent in the principal. The longer the loan term, the higher your interest costs will be.
  • Monthly payments are higher than other types of mortgages: Fully amortized loans have payments covering both principal and interest. Some mortgages, such as balloon mortgages, are not fully amortized and have lower payment amounts until the lump-sum payment is due.

Amortization FAQ

What is full amortization?
Full amortization means every monthly payment contributes to paying off the loan by a specific date (the maturity date). Each monthly payment goes toward a certain amount of principal and interest and will result in a final loan balance of zero by the maturity date. So, if you begin making payments for a 30-year mortgage in February of 2022, you’ll have paid off the loan by January 2052.
Why is amortization important?
Amortization is important because it helps you pay down the loan and build equity at the same time. It also gives you an incentive to make extra payments if you can to pay down principal faster. The faster principal is reduced, the less interest you pay overall.
How do you use an amortization table?
An amortization table maps out your repayment plan. It shows you the payment date, the payment amount, the amount of the payment going toward principal, the amount of the payment going toward interest and the remaining principal balance.

Before you get a mortgage, you can use amortization tables to compare different loan terms. You’ll see that 15-year mortgages have higher monthly payments than 30-year mortgages, for instance, but also that you’ll end up paying much less interest over the life of the loan.

Bottom line

Buying a home can create many expenses you didn't plan for, like the need for major appliance replacements (although a home inspection can help you avoid these surprises). Amortization helps control your costs by letting you pay off your home loan on a predictable schedule, which gives you more certainty when you're creating a budget.

Most mortgage loans are amortized, with the exception of balloon mortgages. Balloon mortgages are risky because you only pay interest for an initial period. Afterward, you’re expected to make a large (“balloon”) payment. You don’t have any equity until you make the final payment.

Did you find this article helpful? |
Share this article