Few things in the home loan environment confuse homeowners as much as amortization and interest calculations. These two particular aspects of having a mortgage are enough to make you pull your hair out. Fortunately, mortgage brokers and bankers understand them. They need to, otherwise their businesses would fail.
Homeowners are better off if they understand both amortization and how interest is calculated. Amortization determines the amount of a homeowner’s monthly mortgage payment. Interest calculations determine how much of each payment goes toward principal as opposed to the amount that goes toward interest.
Confused yet? Keep reading and you will get some much-needed clarity. As you read, remember that Mortgage Maestro is a licensed Colorado mortgage broker designed to be different. We can help you get the home loan you need to buy that house you have your eye on.
The Basics of Amortization
In the simplest possible terms, amortization is the process of spreading out loan payments over time until a debt is completely paid off. The goal is to gradually reduce the book value of the loan with each payment. In a typical home loan scenario, loans are amortized over 15, 20, or 30 years.
The easiest way to amortize a 30-year mortgage would be to take the total amount borrowed and divide it by 360 (there are 360 months in a 30-year span). But such a simple calculation would not account for interest payments, private mortgage insurance (PMI), closing costs rolled into a mortgage, etc.
Mortgage lenders need to take the total cost of borrowing and divide it by 360 to determine monthly payments. Then they must add in an extra amount for escrow – but that is a different topic for another post.
The Basics of Loan Interest
Interest is obviously part of amortization. In terms of what interest actually is, think of it as one of the costs of borrowing. You are paying for the service offered by your mortgage lender. That service costs money. It is charged as a percentage of the amount you borrow.
Perhaps you’ve heard of the term ‘annual percentage rate‘. The word ‘annual’ is included because interest is calculated on a rolling, 12-month basis. Let us use a 12% interest rate just to keep things easy. Hopefully, you’ll never face such a high rate.
Say a rate of 12% is charged over a one-year period. That equals a 1% charge per month. Beginning with your very first mortgage payment, you are paying 1% interest on the total amount you still owe on your mortgage. The portion of your payment left over goes toward what you still owe, also known as principal.
At the start of the second year, interest is calculated on the remaining principal. That amount is divided by 12 and applied to your monthly payments. Every year interest is calculated, the amount you pay goes down because your principal is also going down. The end result is that you pay more principal with every monthly payment – and less interest, too – as time goes by.
Interest Is the Enemy
If you have ever heard financial experts recommend making one extra mortgage payment per year, the way interest is calculated explains why. Interest is the enemy, especially when combined with time. You will pay more interest the longer it takes to pay off your loan. Paying it off sooner reduces the total amount of interest you pay.
Amortization and annual interest calculations are a normal part of the home loan landscape. Feel free to ask your Mortgage Maestro broker about either one when you work with us to secure a home loan.