What is amortization? (2024)

This is how much your loan will cost for the life of the loan

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You’ve just received your first monthly mortgage bill for $2,500. But even if you make the full payment on time, that doesn’t mean your remaining loan amount will drop by $2,500 or that you’ll have that much equity built up in the house yet. That’s because interest plays a big role in your loan payoff.

Understanding this calculation, called amortization, can help you see how much of your monthly payment goes to principal versus interest.

“Amortization refers to the gradual process of paying off your mortgage debt over time through regular monthly payments,” said Alex Shekhtman, CEO and founder of LBC Mortgage. “These payments are thoughtfully structured to cover both the interest and a portion of the principal amount.”

Key insights

  • Mortgage amortization is the gradual repayment of a home loan through set monthly payments of principal and interest.
  • When you first start repaying your mortgage, you will pay more toward interest than principal.
  • Additional principal payments can accelerate the mortgage payoff process, saving you on interest costs and shortening the loan term.

How does an amortization schedule work?

An amortization schedule is a table that outlines the repayment of a loan over time. It breaks down each periodic payment into two components: the principal and the interest.

“In the early stages of your mortgage term, a larger proportion of your monthly payment is allocated toward interest, while a smaller fraction contributes to reducing the principal,” said Shekhtman. “As you consistently make payments over the years, the balance shifts, and more of each payment is directed toward reducing the principal.”

In this example, you can see the amortization schedule for a mortgage of $400,000 with a fixed interest rate of 5% and a 30-year term. This is what the buyer would expect to pay in the first five years — notice more money goes toward the interest:

chart depicting the first five month of the amortization schedule

In the first year, your total interest paid would be $19,865.98. By the fifth year, you would have paid $96,152.12 in total interest.

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

chart depicting the last five month of the amortization schedule

When you make the final payment at the end of 30 years, your loan will be completely paid off. The total interest paid by the end of the loan will be $373,023.14. This is in addition to the $400,000 paid toward the principal.

Calculating amortization

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

Principal payment = monthly payment - interest due for the period

Let’s go back to the example of the $400,000 loan at 5.00% interest for 30 years and calculate the components of the third monthly payment. First, calculate the interest due for the month by multiplying the monthly interest rate (0.05 divided by 12) by the remaining loan balance. In our example, the monthly interest rate is 0.416667%.

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 $399,036.76. When you multiply this figure by the monthly interest rate, you get $1,662.65. This is how much interest will be due for your third monthly payment.

To calculate how much principal is paid down in each payment, you subtract the interest from the fixed monthly payment. That’s $2,147.29 minus $1,662.65, which equals $484.64. The principal will be reduced by $484.64 with the third monthly payment.

Amortization vs. depreciation

Amortization is similar to depreciation in that both concepts reflect a gradual 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 time. If you bought a car a few years ago, it’s likely not worth as much now as it was when you first purchased it. Similarly, you might have heard of businesses depreciating their assets and assigning expenses to these devaluations each year.

» MORE: How much house can I afford?

Benefits of amortization

“For buyers, comprehending amortization helps in grasping how their monthly payments are distributed and how their equity in the property grows with time,” said Shekhtman. “It also presents an opportunity for loan acceleration and reduction of overall interest paid through making extra payments.”

As Shekhtman mentioned, mortgage amortization allows a borrower to build home equity with each monthly payment they make. As the principal is paid down, the homeowner increases their equity, or ownership, in the property. Equity can be useful if the homeowner chooses to sell or refinance the property.

Disadvantages of amortization

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 greater your interest costs will be.

Additionally, some mortgage types, such as balloon mortgages, are not fully amortized and may have low monthly payment amounts until a large lump-sum payment is due. This means facing a significant payment at the end of the loan term and a potential foreclosure if you haven’t saved up enough money to cover that huge payment.

» MORE: How does a mortgage work?

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    Can I change my mortgage's amortization schedule?

    In some cases, borrowers can modify their amortization schedules through refinancing. Refinancing allows a borrower to adjust their loan’s term, interest rate or payment structure to better suit their financial goals or current circumstances.

    How do additional principal payments affect the amortization process?

    Making additional principal payments can significantly impact the amortization process, but it is important to let your lender know that the extra payments are going to the principal only. Extra payments reduce the outstanding principal balance, leading to lower overall interest costs and shortening the loan term.

    What is negative amortization, and should I be concerned about it?

    Negative amortization occurs when a borrower's mortgage payment is not sufficient to cover the interest due. As a result, the unpaid interest is added to the loan's principal balance. Negative amortization can be a concern with payment-option adjustable-rate mortgages, but it won’t affect most homebuyers with standard mortgages.

    Bottom line

    An amortization schedule provides a roadmap for a borrower, letting them know how much of their monthly payment will go toward principal and interest. Understanding how significant a role amortization plays in your loan can help you decide between a fully amortized mortgage with stable payments and an alternative mortgage type, like a balloon mortgage. It can also motivate you to pay off your mortgage early.

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