Lessons in Loan Lingo: What's "Amortization"?
Picture my husband and I, long time renters, neither of us even ever having had a car loan, sitting with a mortgage broker, discussing our options for financing a home. We thought we were educated, but nothing made us feel clueless faster than the mortgage process, with its acronyms and obscure terminology. That feeling is what this series of “lessons in loan lingo” blogs is meant to save you from.
Last week I talked about PITI. It’s not, as I first guessed, and affectionate name for a diminutive pit bull, but rather stands for Principal, Interest, Taxes and Insurance, the four parts that make up a mortgage payment. Today, I’m defining amortization.
Again when I first heard this word (and it came up a lot in our first meeting with a loan broker), I did my best to guess at its meaning. But my background in teaching English didn’t help much, because I fixated on the root “mort” and wondered why someone had to die in order for us to get a mortgage.
Actually, amortization is a good thing. It is the process by which you, the borrower, reduce your debt. As you paying principal and interest on the schedule you set up with your lender, you make your way toward paying the home off by the end of the loan’s term.
Different Mortgages, Same Rules
All loans amortize, or are paid off, by the end of the agreed term if the borrower makes his/her payments.
- Fixed-Rate Mortgages
If you opt for a 15 -year or 30-year fixed mortgage, your loan amortizes in 15 or 30 years, meaning it’s paid back by the end of that term—as long as you made your payments in full and on time.
Borrowers can more easily see the advantage of a 15-year fixed loan when looking at amortization: since interest compounds over time, if you’re paying the loan off more quickly, you pay less interest, which means by the end of 15 years, the original loan money costs you much less than it does the borrower of a 30-year fixed.
- Adjustable-Rate Mortgages
Adjustable rate mortgages (ARM) also amortize, even though the amount of interest you pay may fluctuate over the course of the loan’s terms. If you stay in a home for 15 years, making regular payments on a 15-year ARM, your home is paid off after those 15 years.
Interest vs Principal
Because of the way loan payments are set up, initially you mostly pay interest, with less going toward principal. But over time, that shifts, and your payments change to allocate more to principal and less toward interest. If you look at your monthly statement, you can see how much is going toward each, and how much is left of each—a figure that I’m told gets less depressing as the years go by. As my husband and I have only made 3 house payments so far, we’re mostly paying interest. We certainly look forward to paying down principal as well!
Calculating Your Amortization
If you’re Excel savvy, it’s not too hard to set up an amortization table for yourself to figure out the monthly and yearly figures you’ll be paying during the life of your loan. However, there are some easy calculators online, already set up, like this one from Amortization-calc.com.
Here I’ve entered a basic set of numbers (yours will most likely vary, of course). And next, I see what I’ll pay total by the time my loan term ends.
With these figures, you'd pay almost double your orignal loan amount by the time you pay it off-- actually quite the incentive to pay a bit more every month if you can each month, just to end up paying less overall. But then, making extra payments on a loan, being a complicated topic as well, belongs in another blog. In the meantime, at least none of us have to feel intimidated (or clueless) when a loan broker asks us to comment intelligently on amortization. Knowledge, dear readers, is priceless.
More of that Knowledge:
Anna Marie Erwert writes from both the renter and new buyer perspective, having (finally) achieved both statuses. She focuses on national real estate trends, specializing in theSan Francisco Bay AreaandPacific Northwest. Follow Anna on Twitter: @AnnaMarieErwert.