Amortization. It can be a daunting word, but it’s not as complicated as it sounds. When it comes to mortgages, amortization refers to a debt being paid down with fixed monthly payments over a fixed period of time.
A typical home loan is made up of two components, principal and interest. The principal amount of the monthly payment goes towards paying down the overall loan balance, while the interest portion of the payment is paid to the bank as a fee on the money borrowed and does not reduce the total loan amount.
The monthly payment on a fully amortized fixed-rate mortgage is determined by adding the original loan amount to the total interest amount to be paid over the life of the loan and dividing the total by the loan duration in months. This results in a consistent payment every month over the life of the loan.
While the total monthly payment remains the same over the life of the loan, the amounts allocated to principal and interest within each payment vary every month. At the start of the loan, the portion of the payment going to principal is low and the amount going to interest is high. As time moves on, the principal amount paid increases and the interest amount paid decreases.
Take a look at the graph below to see how the principal and interest payments over time impact the loan balance shown in green.
A variety of calculators are available online that can create charts like the one shown above, indicating the principal and interest amounts over the duration of the loan for specific loan amounts, durations, and interest rates. These calculators will also generate a table of the monthly interest and principal payments over the course of the loan – referred to as an amortization schedule.
Let’s look at a specific example. For a 30-year fixed-rate mortgage of $250,000 at 3.5% interest, the total amount of interest paid over the life of the loan would be $154,140. Adding the original principal balance of $250,000 to the total interest paid results in a total loan cost of $404,140 ($250,000 + $154,140). This represents the total amount to be paid over the course of the loan. Dividing by the 360 months for a 30-year term results in a monthly payment of $1,123.
Below is an example of what the amortization schedule would look like for this loan. Although the full schedule would include all 30 years, only Year 1 and Year 30 are shown below for reference.
In the first month of Year 1, out of the $1,123 total payment, the principal amount reduces the loan balance by only $393. Each month the amount of principal slowly increases. By the end of the first year, $13,464 in mortgage payments reduce the total loan balance by only $4,798.
The beginning of the loan is also the time when large additional principal payments will make the biggest impact in reducing the duration of the loan. If it is possible to make extra payments in addition to the regular monthly payment, doing it early on will shorten the loan term more than if the same payment was made later.
As time goes on, the principal amount continues to increase and the interest amount continues to decrease. By year 30 things have changed dramatically! More than $1,000 of principal goes toward paying down the loan each month. Over the course of the final year, the same $13,464 of mortgage payments reduces the loan balance by $13,220, paying off the mortgage!
Stay a While
As of the beginning of 2020, the average U.S. homeowner only stays in their home for about 8 years. Many others refinance their mortgages often to lower their monthly payment or take equity out of their homes. Moving or refinancing results in a new mortgage loan and a reset of the “frontloading” effect of the interest payments. By doing this, the borrower won’t get far enough into a mortgage term to experience the benefits of higher principal payments, not to mention the other costs associated with refinancing or selling.
Staying in your home over a long period of time without refinancing allows the principal payments to grow over time, paying down the loan balance while building equity in the home and creating wealth.
Consider the Total Cost of Ownership
Many people mistakenly think that 100% of mortgage payments go directly to building wealth and equity and that renting is just throwing your money away. While it is true that there are many benefits to owning a home, there are a lot of unrecovered costs as well. Mortgage interest, along with property taxes, homeowner’s insurance, and the costs associated with buying and selling a home, all must be considered when determining whether or not it makes sense to buy.
As housing is often the largest single expense for many families, it is critical to fully understand the costs of homeownership in order to make good decisions regarding how much to spend on a home. Limiting spending on housing purchases is often the best way to dramatically reduce monthly expenses and allow more room for debt payoff, investing, and improving overall financial health. To find out if now is the right time for you to step into homeownership, contact our Financial Advocates or attend one of our Homebuyer Workshops.