Amortization- what is it and how does it work? Part of a successful mortgage plan is amortization. Knowing how this works can help you save a lot of time and money on your mortgage loan. Here is all you need to know.
What is amortization?
The definition of Amortization is the action or process of reducing or paying off debt with regular payments, also known as the process of writing off the initial cost of an asset. So, what does that mean in terms of a mortgage loan? As you know, you pay your monthly mortgage payments for a period until your loan is paid off. This payment is made up of both principal and interest. Principal is the part of the payment that goes directly to paying off your home (or asset). Interest is a percentage of the loan that you will pay at a particular rate for the repayment of a debt. Although you are paying the same amount each month, every month there is a different break-up of how much of your monthly mortgage payment goes to principal, and how much goes to interest. Why is it important for you to understand this? Well, you can utilize an amortization schedule to save you money in the long run.
How does amortization work?
Therefore, amortization is essentially paying off a loan in regular payments. Mortgage lenders will use an amortization schedule to show the following:
- What each payment is made up of -the breakdown of principal and interest
- How this breakdown adds up to your complete loan amount.
To further explain, to calculate the amount of interest you pay each month you take your given interest rate and divide it by the number of months in a year. Then, that number is multiplied by the current balance of your mortgage. After that, the principal is added to make up your monthly payment. The principal amount is then determined by how much is necessary to repay your mortgage loan by the end of the term. The amortization is recalculated monthly, as the interest depends on the balance of your mortgage which is going down every month. The visual below may help may help to further explain this better.
While the payment is consistent, there is a different amount that goes towards interest and principal every month. In the beginning, you are paying less principal and mostly interest. As you pay-off your loan, more of your payment starts going towards your principal balance.
Bottom Line- How to SAVE money with amortization?
The reason this matters to you is because if you utilize an amortization schedule, you could save money over the life of your loan. You will pay less interest as you pay-off your mortgage amount. By paying more than your monthly payment every month, you are putting the extra money straight towards the principal amount. The extra money you re-pay each month does not get split with any interest payments. Since the extra money goes to reducing the principal amount, you are greatly reducing the total mortgage amount. A lower mortgage amount means a lower interest payment. In the long run, paying more monthly will lessen the amount of interest you have to pay. This will allow you to pay-off your loan faster and could save you money.
Keep in mind, there are some instances where some mortgage products have restrictions on early pay-off. Contact our team to learn if this is a financial tactic you should implement.
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