Amortization: What Is It & How Does it Work?

You may or may not have heard the term 'amortization' before, but what does that mean? Today we're walking you through it...

Amortization: what is it and how does it work?

A general definition of amortization is a gradual reduction of debt over time.

A definition of mortgage amortization is a process by which a portion of your monthly payment is applied to your loan to reduce the balance.  

If you have a fully amortizing mortgage, then payments will reduce your loan balance to $0 by the end of the term.

To understand mortgage loan amortization let's look at things that don't amortize

When you buy a new laptop on your credit card, such as a Panasonic Toughbook, your credit card balance increases by the amount of the cost of the product. Let's say you have a $5,000 limit starting with a $0 balance and you buy a $2,000 laptop. Your new credit balance is $2,000; will that balance amortize? NO! Credit cards are a form of revolving credit and you are only required to make the minimum payment calculated by your credit card company, which is usually the lower of 2% of your outstanding balance or a range of $15-$35. In order to reduce your balance to $0, you will have to do your own calculations of what your timeline is and take into account how much interest will accumulate during that period.   

What if you decide to combine your first mortgage with a piggyback home equity line of credit (HELOC) to avoid having to pay private mortgage insurance (PMI). Will the HELOC amortize? HELOCs have features of both an amortizing loan and a revolving line of credit. A standard example of a 30-year product starts with a 10-year draw period during which you only make interest payments, followed by a 20-year amortization period where your payment includes both principal and interest.  

What if you want to finance a new Jeep Wrangler hybrid like this one? Car loans are typically fully amortizing loans; a 60-month car loan will have monthly payments that include both principal and interest to reduce the balance to $0 by the end of the term.

One of the reasons car loans mature in less than 7 years typically, vs. 30 years for the standard mortgage, is because the size of the loan dictates how long to stretch the payments out for to make them affordable. The second factor is that the useful life of the asset can put an outer limit on the maximum term of the loan that makes sense (you don’t want to be making payments on something that no longer has any value, and the lender doesn’t want to have a loan outstanding without any remaining collateral value). As a consequence of the Great Depression in the 1930s, the FHA program was born, and along with it, longer mortgage terms up to 30 years, and lower down payments, became standard. The longer loan terms and lower down payments helped make housing affordable.  

The above table shows how much of your principal has been amortized by certain points in the life of the loan. One of the things you will notice is that the higher the mortgage rate, the more backended the principal payment becomes (i.e. after ten years, a 5.0% rate mortgage will only pay down 18.7%, vs. 24.0% for a 3.0% rate mortgage). Based on the latest statistics, the average homeownership duration is about eight years, and only 37% of Americans have been in their homes more than ten years. That means very few Americans are coming close to paying down 50% or more of their mortgage while in their current home.   

We recommend using this calculator to see and learn more about how the breakdown of principal and interest paid during the loan is impacted by the terms of the loan (rate and maturity).

Mortgage amortization is a standard feature and not something that needs to be “shopped”. However, different types of loans (such as fixed vs. adjustable rate) react differently to prepayments (in one case, your monthly payment changes going forward, and in the other case, your loan term shortens). If you expect to have windfall income during the time of your loan, such as from bonuses, inheritances, etc., and you think you might want to make extra payments on your mortgage, you should be aware that ARMs will be more attractive if you want to reduce your monthly payments after a prepayment, while FRMs will be more attractive if you want the loan term to be shortened instead while keeping the payment the same. 

READ NEXT: Current Mortgage Rates: US Bankrate Updates | Compare Current Rates

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