When you take out a loan, such as a mortgage or auto loan, the loan is separated into two main parts: the principal and the interest. The principal is the original sum of money that you borrowed in the loan. The interest is how much the lender or bank charges you to take out this loan.
Amortization is how you pay off the debt with regular payments until loan maturity or when the loan is paid off. In real estate, you will likely see an amortization schedule. This schedule or chart breaks down your payment and shows how much of it goes to interest and how much goes to the principal.
Amortization helps give borrowers a reasonable expectation of their monthly payments. It is the process of gradually reducing the mortgage down to zero. With amortization, the monthly payments appear more affordable. As a result, more people can afford one, and there is less probability of the borrower defaulting. At the end of the loan, the bank has profited from their investment, and the borrower owns the property.
Here is an example of how the principal balance is paid down or amortized over the term of the mortgage for a $200,000, 30-year fixed rate mortgage, with a 4.5% interest rate and a 10% down payment.
Your total payment will be the same amount each month. However, amortization dictates that the amounts paid towards principal and interest changes over time. If you look at the graph below, you’ll see an example of how the principal and interest components of the mortgage payment fluctuate while the mortgage payment itself remains constant.
In the beginning, most of your payment goes to the interest. Approximately 90% of the money goes toward the interest, and only 10% goes towards the loan principal. As a result, if you default on your loan early, the bank has already profited some.
The further you get into your loan term, the higher the percentage of the money will go towards your principal. Naturally, a lower portion of the money will go towards interest.
Here is a sample amortization schedule for a $100,000 15-year fixed mortgage with a 4% interest. The principal amount is $100,000, and the amount paid in interest is $33,144.
|Month||Interest Payment||Principal Payment||Monthly Payment||Remaining Balance|
By the 360th month, you will have completely paid off your mortgage.
With such a detailed breakdown of your loan, you can visually see where your money goes. Therefore, instead of exclusively looking at how “affordable” the monthly payment is, you can now see how much interest you are truly paying for this loan. This is why some consumers choose to pay off their loan early to skip all of the remaining interest charges. Of course, this may incur an early repayment penalty, which must be weighed before making this decision.