What Is Mortgage Amortization?

Definition

Mortgage amortization is a repayment schedule that outlines how a borrower's monthly payments are allocated towards paying off a mortgage loan, developed from the principles of actuarial science.

How It Works

Mortgage amortization works by dividing the borrower's monthly payment into two parts: interest and principal. The interest portion is calculated based on the outstanding loan balance, while the principal portion is the amount applied towards reducing the loan balance. At the beginning of the loan, a larger portion of the monthly payment goes towards interest, with a smaller amount going towards principal. As the loan progresses, the interest portion decreases, and the principal portion increases, allowing the borrower to pay off the loan more quickly. The time value of money, a concept introduced by Eugen von Böhm-Bawerk, plays a significant role in determining the amortization schedule, as it takes into account the present value of future cash flows.

The amortization schedule is typically calculated using a formula that takes into account the loan amount, interest rate, and loan term. For example, a $200,000 mortgage loan with a 30-year term and an interest rate of 4% would have a monthly payment of approximately $955. The amortization table would show that in the first year, about $8,300 of the total payments made would go towards interest, while about $1,300 would go towards principal. As the loan progresses, the amount applied towards interest decreases, and the amount applied towards principal increases. The loan-to-value ratio, which is the ratio of the loan amount to the value of the property, also affects the amortization schedule, as it determines the amount of equity the borrower has in the property.

The amortization schedule can be affected by various factors, including changes in interest rates and loan terms. For instance, if the borrower were to refinance the loan to a 20-year term, the monthly payment would increase to approximately $1,121, but the total interest paid over the life of the loan would decrease by about $30,000. This is because the borrower is paying off the loan more quickly, reducing the amount of interest accrued over time. The Federal Reserve's monetary policy decisions, such as setting interest rates, can also impact the amortization schedule, as changes in interest rates can affect the borrower's monthly payment and the overall cost of the loan.

Key Components

• Loan amount: The initial amount borrowed by the borrower, which affects the monthly payment and the total interest paid over the life of the loan. An increase in the loan amount would result in a higher monthly payment and more interest paid over time.
• Interest rate: The rate at which interest is charged on the loan, which affects the monthly payment and the total interest paid over the life of the loan. A higher interest rate would result in a higher monthly payment and more interest paid over time.
• Loan term: The length of time the borrower has to repay the loan, which affects the monthly payment and the total interest paid over the life of the loan. A shorter loan term would result in a higher monthly payment, but less interest paid over time.
• Monthly payment: The amount the borrower pays each month, which is calculated based on the loan amount, interest rate, and loan term. An increase in the monthly payment would result in the loan being paid off more quickly, reducing the total interest paid over time.
• Amortization table: A schedule that outlines the borrower's monthly payments and how they are allocated towards interest and principal. The table provides a detailed breakdown of the loan's repayment schedule and helps the borrower track their progress.
• Equity: The amount of ownership the borrower has in the property, which increases as the borrower makes payments and reduces the loan balance. An increase in equity would result in a lower loan-to-value ratio, making it easier for the borrower to refinance or sell the property.

Common Misconceptions

Myth: Mortgage amortization is only used for residential loans — Fact: Amortization is used for all types of loans, including commercial and industrial loans, as it provides a clear understanding of the loan's repayment schedule and the borrower's obligations.

Myth: The borrower's monthly payment remains the same over the life of the loan — Fact: While the monthly payment may remain the same, the amount applied towards interest and principal changes over time, with more interest paid in the early years and more principal paid in the later years.

Myth: Amortization only applies to fixed-rate loans — Fact: Amortization can be applied to both fixed-rate and adjustable-rate loans, as it provides a clear understanding of the loan's repayment schedule and the borrower's obligations.

Myth: The borrower can only make one extra payment per year towards the principal — Fact: There is no limit to the number of extra payments a borrower can make towards the principal, and doing so can significantly reduce the total interest paid over the life of the loan, as demonstrated by David Bach's "Finish Rich" strategy.

In Practice

In the United States, the Federal Housing Administration (FHA) provides mortgage insurance to borrowers who purchase homes with low down payments. For example, a borrower who purchases a $250,000 home with a 3.5% down payment and a 30-year mortgage at 4% interest would have a monthly payment of approximately $1,194. The amortization table would show that over the life of the loan, the borrower would pay a total of $183,000 in interest, in addition to the original loan amount. However, if the borrower were to make an extra payment of $1,000 per year towards the principal, they would save approximately $20,000 in interest over the life of the loan, as calculated using the Mortgage Bankers Association's mortgage calculator.