Amortization is a financial concept with multiple applications. For example, business owners rely on amortization to express the value of their assets for tax purposes. Investors rely on amortization for similar calculations. But when it comes to home loans and the mortgage market, amortization has a completely different application.
Mortgage lenders rely on amortization to calculate a homebuyer’s monthly mortgage payments over the life of the loan. Note that it only accounts for principal and interest. Monthly mortgage payments can increase from year to year as a result of higher insurance costs and tax increases.
Lenders and mortgage brokers do not expect buyers to understand the finer details of how amortization works. In fact, calculating amortization over a 30-year mortgage requires some complex math. Still, understanding the basics of amortization can make it easier for buyers to grasp what goes into their monthly mortgage payments.
Principal Plus Interest
The two main components of amortization are principal and interest. Principal is the amount of money you borrow from a banker mortgage lender. Interest is the amount of money you pay for the service you are getting. Here is an easy example to understand:
Imagine you were asking to borrow $100 with a 10% interest rate. The total amount you would repay is $110. The initial $100 is the principal while the additional $10 is the interest payment. You make that interest payment to cover the service provided by your lender.
Things get much more complicated on multi-year mortgages. The reason boils down to the fact that interest is recalculated at the start of every year. Let us choose an arbitrary interest rate of 7%. Your total interest payments during the first year of your mortgage are equal to 7% of the outstanding balance at the start of the year.
At the end of that first year, interest is recalculated based on 7% of the remaining balance. This continues every year until the mortgage is paid off. Note that something interesting happens – with every mortgage payment you make, you reduce the amount you still owe.
Flipping the Script
Think about the implications of reducing principal. Because interest is recalculated every year based on the amount of principal still outstanding, your total interest payments for any given year should be lower than previous years. Still, your monthly payment doesn’t change. That is a good thing. Why?
Maintaining the same monthly payment means more money is going toward principal every year. As you pay down principal your interest goes down as well. The less of each monthly payment going toward interest, the more of that payment goes toward principal. By the time you get to the last year of your mortgage, almost all your entire payment is going toward principal.
As a side note, this is why the idea of making an extra mortgage payment annually saves money in the long run. Each extra payment reduces the principal. Every reduction in principal reduces interest.
Keeping Monthly Payments Stable
When you boil amortization down to its basic principles, it is all about maintaining stable monthly mortgage payments. That’s why lenders do it. They want to give home buyers a fixed amount they will pay every month so as to make it possible to establish a housing budget. Without amortization, home buyers would never know how much they might pay from year to year.
As a Colorado mortgage broker, we can do the amortization for you. We run the math and come up with an estimated monthly amount you can work into your housing budget. Just do not forget taxes and insurance. Both are flexible from one year to the next. If you want to work with a trusted and knowledgeable mortgage broker, call us at 303-779-0591 or schedule a free consultation today.
