Mortgage amortization describes the process of how the principal and interest on a home loan are repaid over time. Knowing how a mortgage amortizes can help you discern the cost of buying a home.
As you compare mortgage terms and interest rates, here is how you can decode your loan's amortization schedule.
[Read: Best Mortgage Lenders.]
What Does Amortization Mean?
"Amortization is simply a form of paying off debt over time through regular loan payments," says Andy Harris, president of Vantage Mortgage Group.
Mortgages are amortized, but you can also have amortization with other types of loans, such as auto, personal or student loans.
The payments are broken down on an amortization schedule from the lender. This schedule shows how much principal and interest you will knock out with each payment until the loan is paid in full.
If you do not get an amortization schedule from your lender, you should ask for one.
What Is the Difference Between Your Mortgage and Amortization?
You may have used a mortgage to build or buy your home. Your mortgage is an agreement between you and your lender that allows the lender to take your property if you don't pay as agreed.
The lender can do this through a foreclosure proceeding and sell your home to recover the outstanding balance on the loan.
Mortgage amortization, on the other hand, does not create debt obligations. It is just a way to explain the debt you owe.
[Read: Best Mortgage Refinance Lenders.]
How Does Mortgage Amortization Work?
When you take out a mortgage to buy a home, it includes two basic components: principal and interest. Your lender will require you to have an escrow account to pay property taxes and homeowners insurance premiums.
You could also roll these amounts into your payments for principal and interest. Either way, amortization spreads out your loan payments and pays off the loan at the end of the term.
Whether your mortgage is fixed or adjustable rate, you will pay more in interest at the beginning of your loan term, when your principal balance is high.
Later, the bulk of your payment shifts to paying down the principal, says Jordan Benold, certified financial planner at Benold Financial Planning. "Each monthly payment of a mortgage adds more principal until the very last payment, which is almost 100% principal," he says.
Structuring amortization in this way allows your lender to capture more interest in the beginning of the term. This works in the lender's favor if you decide to sell the home in the first few years or refinance for a lower rate.
How Do Lenders Calculate Mortgage Amortization?
Lenders rely on a standard formula to set a mortgage amortization schedule for homebuyers. This formula includes three numbers: principal loan balance, interest rate and loan term.
You can figure out amortization for a home you're interested in buying using your lender's online calculator, or you can do the math on the mortgage payment yourself.
Calculating your mortgage amortization and payment before committing to a loan is useful for determining:
-- How much of your payment goes toward principal versus interest each month
-- How much interest you'll pay for a mortgage based on the loan term, amount and estimated interest rate
-- How interest charges could vary for different loan terms, such as 15-, 20- or 30-year mortgages
-- How much money you could save by refinancing your mortgage at a lower interest rate
-- How much you could save with extra principal payments
-- How much equity you have in your home
How to Read Your Mortgage Amortization Schedule
If you've been approved for a home loan and signed off on the paperwork, your lender should provide you with a mortgage amortization schedule. If your mortgage hasn't been finalized, your lender should give you a loan estimate showing what you'll pay.
Once you have your amortization schedule, take time to get familiar with it. Specifically, look at:
-- How many payments you have to make
-- When the first payment is due
-- When the final payment is due
-- How each loan payment divides principal and interest
-- When you'll hit 20% equity and may be able to remove private mortgage insurance
Your mortgage amortization schedule may include other details about your loan. For example, yours might show how much interest you've paid so far.
It may or may not show you how much you could save by making extra principal-only payments.
Most mortgage amortization schedules won't show any fees you might pay. For instance, your lender might charge an origination fee or a prepayment penalty if you pay off your loan before a certain date.
You can reach out to your lender to learn more about what fees, if any, you're paying and how those are paid.
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