As you make payments on your mortgage, your balance decreases over time. These payments are a mix of both principal and interest. Mortgage amortization is a concept that allows your monthly payment to remain the same while the mix of principal and interest changes throughout the life of the loan.
In this article, we'll define what mortgage amortization is, how it works, and how you can calculate it. Plus, we'll walk through an example to show its benefits and how a shorter-term loan could save you money.
What is mortgage amortization?
When researching how to get a loan, you'll come across the term "mortgage amortization." This concept describes how your monthly mortgage payments are a mixture of principal and interest. This mixture is based on the balance remaining on the loan.
At the beginning of the loan, the majority of your payment is interest, with a small portion of the payment reducing your principal balance. Over time, the principal portion of your payment increases while the interest decreases — but your overall loan payment remains the same.
Your payments follow a detailed mortgage amortization schedule that is included in the stack of documents you signed when you finalized your loan. This amortization schedule, also sometimes referred to as the mortgage amortization table, defines how much of each payment is principal and how much is interest over the course of your mortgage.
How mortgage amortization works
Mortgage amortization determines how much of your payment goes to principal versus interest each month as your mortgage balance declines. The mortgage amortization formula affects only the principal and interest portion of your monthly mortgage. If you have other costs rolled into your mortgage payment — such as private mortgage insurance (PMI), taxes, HOA dues, homeowners insurance — those are not affected by this formula.
Each month, a portion of your payment reduces the balance of your mortgage. As the mortgage balance decreases, the interest charges become smaller. This allows more and more of your monthly payment to reduce the mortgage balance.
Although it may seem like your mortgage balance is not decreasing that quickly in the beginning, the process is like building a snowman. It starts out small and gets bigger and bigger over time until you've reached your goal.
Most mortgage payments are designed to pay off the loan amount by the end of the term. This means your final payment is close to 100% principal and results in a zero balance. In rare instances, the final payment is a set amount known as a balloon payment. Balloon payments are the balances remaining that must be paid off or refinanced at the end of your loan term.
The mortgage amortization formula
Although there are numerous free mortgage calculators available online, it helps to understand the math behind the amortization concept. You will need some basic information from your home loan documents or monthly statement, and then you can calculate how much of your payment is interest versus principal.
The formula to determine the split between principal and interest is the following:
Principal Payment = Total Monthly Payment – [Outstanding Loan Balance x (Interest Rate / 12 Months)]
To create a full amortization schedule, you would need to do this calculation for each monthly payment for the life of your loan. This process can get complicated, so it is far easier to use an online calculator instead of calculating it by hand.
A mortgage amortization example
Let's use a real-world example based on a 30-year loan for $250,000. This is a fixed-rate mortgage with a 3% interest rate, so the monthly payment is $1,054.01.
Of this monthly payment amount, the interest portion is calculated by multiplying the mortgage balance by the interest rate and then dividing by the number of months in a year.
In our scenario, the $250,000 mortgage balance times 3% is then divided by 12. The formula is $250,000 x 3% / 12 = $625.00. This matches the interest portion of the first payment in the amortization schedule below.
Therefore, we can also determine that the principal amount of the first payment is $429.01 after subtracting $625.00 of interest from the monthly payment of $1,054.01.
After the first payment, the new mortgage balance is $249,375, which is $250,000 minus $625. To determine the interest versus principal payment breakdown for the second month, repeat the process starting with the new balance of $249,375.
As you can see in the amortization schedule below, the interest portion of the payment starts out high but decreases over time as the balance decreases.
|Payment date||Payment||Principal||Interest||Total interest paid||Mortgage balance|
Mortgage amortization: short- vs. long-term loans
The length of your loan greatly impacts the loan amortization schedule of your mortgage. Many people choose a 30-year mortgage because it spreads out the repayment of the loan. However, when you choose a 15-year mortgage, the loan is repaid more quickly and you'll pay less in interest charges.
Having a shorter loan term greatly reduces the amount of interest you're paying two ways:
- You're paying more principal each month, so the mortgage balance declines quicker, which means there is a smaller balance to charge interest on each month.
- Because the loan term is shorter, you'll make fewer payments that include interest.
The downside of having a shorter mortgage is that your payment will be larger for the same size mortgage. But getting a 15-year loan could save you a significant amount of money if you can afford the payments. When comparing the total interest payments of a $250,000 loan at 3% over 15 or 30 years, you'll save over $68,000.
|Loan amount||Interest rate||Term||Monthly payment||Total payments||Total interest|
|Difference in interest paid||$68,681.89|
Choosing a 15-year vs. 30-year mortgage
The best mortgage lenders will explain your options and help you decide which mortgage is best for your situation, including the number of years you finance for. Some people prefer the peace of mind from having their home paid off quickly. Other homebuyers would prefer to invest the difference in payment in the stock market to try to earn higher returns than the amount they could save on their loan. There's no one right way to do it because the decision can often be more emotional than mathematical and will also depend on each household’s financial goals.
If you are already a homeowner, keep in mind that when current interest rates are much lower than your original mortgage rate, that is a good reason to consider refinancing. Some people take advantage of the lower rates to shorten the remaining term on their 30-year mortgage and take out a 15-year mortgage instead. The savings from the rate drop can help to offset the increase in principal payment with the shorter loan. These kinds of markets can be a chance to save both on your rate and on the overall interest you pay over the life of the loan.
My family did this with our home in Nashville, Tennessee. We bought the house with a 30-year mortgage at 4%. We refinanced it a couple years later into a 15-year loan at 2%. Our monthly payment went up a couple of hundred dollars, but the mortgage will be paid off more than 10 years sooner than originally planned. Plus, it saves us tens of thousands of dollars in interest payments.
Why it’s important to understand mortgage amortization
Mortgage amortization is an important concept to understand as you buy or refinance your primary residence or if you’re learning how to invest in real estate. In fact, mortgage amortization is one of the five primary ways to build wealth through real estate. Here are the five ways, briefly explained:
- Forced appreciation: Rehabbing the property to increase its value
- Market appreciation: When all properties in the area increase in value due to economic trends
- Cash flow: The profits left over after subtracting expenses and mortgage payments from rental income
- Tax benefits: Homeowners can deduct their mortgage interest and property taxes, however, the standard deduction is so high that most homeowners will not benefit from itemizing their deductions. Landlords can deduct depreciation on a rental property to reduce the taxes owed on the profits from your rental
- Mortgage amortization: Paying down your mortgage balance each month to increase the equity you have in the property
Understanding the mortgage amortization schedule and how the concept works enables you to build wealth faster. You can build home equity by paying extra toward your mortgage balance. The reduction in the amount owed also reduces the amount of interest you'll pay over the life of your mortgage.
Paying extra on your mortgage not only reduces the amount of interest you'll owe, but it can also pay your loan off early. One strategy is to make the equivalent of one extra mortgage payment each year in addition to your regular payments. In the end, this strategy can shave more than four years off of a 30-year mortgage.
Making one extra mortgage payment per year can be accomplished in several ways:
- Dividing your normal principal and interest payment by 12 and adding that amount to each monthly payment.
- Paying an extra payment from your savings, bonus, tax refund, or another windfall each year.
- Signing up for bi-weekly payments (many lenders offer this service for a small fee).
Some homeowners choose a 15-year vs 30-year mortgage because of the "forced savings" of building equity faster and paying their home off early. Others choose the 30-year mortgage to have a lower minimum monthly payment. Then, they calculate what the 15-year payment would be and pay that amount each month. This way, they are paying the property off early, but have the flexibility to pay a lower amount in case one spouse loses a job, major expenses occur, or someone gets sick.
But behind all of these payment strategies is an understanding of how amortization works and how it can be employed to get you ahead financially.
Are all mortgage loans amortized?
Most mortgage loans eventually have an amortization schedule. Some loans have interest-only payments for a period of time before they start amortizing or are required to be paid in full. Non-amortizing loans are fairly rare in today's market, but they can be appropriate for some borrowers under the right circumstances.
Can you change your amortization schedule?
Your mortgage amortization schedule defines how much principal and interest you'll pay each month over the course of your mortgage if you make every payment on time. Every extra principal payment you make changes the amortization schedule because it reduces the mortgage balance that your monthly interest payment is based on. Whether you make one additional payment or pay extra every month, you are changing your amortization schedule and speeding up your mortgage.
Does paying an extra $100 a month on a mortgage help?
Yes, by paying extra on your mortgage every month, you are reducing your balance faster. The smaller your mortgage balance, the less interest you pay each month. With less interest paid, that leaves more of your monthly payment to reduce the mortgage balance even faster. Depending on your mortgage balance, extra payments could shave years off your loan term. However, keep in mind that paying extra to reduce your balance will not change your monthly payment. That same minimum monthly payment is due until the loan is paid off.
A mortgage amortization schedule shows how much of your mortgage balance you'll pay off each month if you make every required payment on time. You can calculate what portion of your monthly payment is interest versus principal easily using an online calculator.
Paying extra toward your loan balance can reduce the amount of interest you pay and the term of your loan. This is especially true in the beginning when the majority of your payment goes to paying interest. Understanding how amortization works and using a well thought-out strategy to expedite the payoff of your loan will bring you closer to being mortgage debt-free.