Amortization of loans occurs when the borrower makes fixed monthly payments to the lender. These payments include principal and interest, and the loan balance decreases as the borrower makes these payments.
Real estate professionals who are unfamiliar with the amortization process can put themselves and their clients at risk. As a future real estate professional yourself, you need to learn about the ins and outs of amortization from trusted experts like us.
In this post, we’ll define amortization and amortization schedules and explain how to calculate amortization with the help of an example. Let’s dive into the details!
What Is Amortization?
Amortization is an accounting process in which the book value of a loan or an intangible asset periodically reduces through regular payments. It is the process of writing down the value of a loan or an intangible asset over a set period. Intangible assets or loans are expensed or amortized over time, and the cost is distributed during this time.
Amortization of loans involves regular payments that include principal and interest during the loan term. It is important to understand amortization as it helps lenders and borrowers analyze and forecast the cost of the loan over the period. Amortization also tells about the portion of the loan payment that consists of principal and interest.
Mortgage amortization is the process that is used to pay off a home loan. The payment amount is fixed monthly if it’s a fixed-rate mortgage. When the loan is created, the series of fixed payments are usually created through the amortization schedule.
The payments during this period are fixed, but the principal and interest amounts change from one month to the next. In each payment, a part of the payment goes towards the loan, and the other is towards interest. When the loan amortization takes place, the amount that goes towards the principal is small at the start, increasing gradually as payments are made every month.
Amortization Schedule
A loan amortization schedule displays all the periodic payments of the loan in a table form, indicating the principal and interest for each payment. The schedule is used to reduce the loan balance through installment payments. The amortization table includes all the details and payments required for reducing the loan.
The amortization schedule indicates the loan amount, balance at each payment, amortization period, interest rate, a portion of each payment for interest and principal, and the total payment amount. An amortization schedule uses the following formula for quick calculations of the loan details for each month:
Most of the payment in a loan goes towards the interest and not the principal. A loan amortization schedule indicates how the loan progresses until the loan is paid in full until the loan matures at the end of the term.
The longer the term, the more the cost of the loan and the smaller the monthly payments. On the other hand, for the short term, the monthly payments are higher. Monthly mortgage payments depend on various factors, which include the interest rate, principal loan amount, loan term, and monthly interest rate.
Banks or credit unions provide the amortization schedule to the loan receiver. This schedule is provided when the loan is extended to the borrower. This helps the borrower understand the payment structure in a better way.
How Does the Amortization Schedule Work?
An amortization schedule includes a lot of factors for calculating amortization. An amortization schedule has five to six columns depending on the loan requirements. The amortization schedule can be calculated on a monthly or annual basis. The following are the main components of an amortization schedule:
The Period
The period or year in this column indicates the bi-weekly, monthly, quarterly, or annual payment on the loan. Each row on this schedule determines the payments that will go on each payment schedule. This helps the user plan a budget and break down the cost of the loan.
Principal
The principal portion of the loan is the payment that is left after subtracting the interest payment from the total amount. The principal payments are smaller at the start of the loan, but they gradually increase during the loan term.
Interest
Interest is the portion that the borrower has to pay as an expense of the loan. The interest payment is often calculated as the current loan balance multiplied by the interest rate. The interest rate varies from lender to lender. Besides, the borrower can get better rates if their credit score is high.
Total Payment
The total payment is the monthly payment that the borrower has to pay. This payment includes the principal and interest. The total payment on the loan remains the same throughout the loan term.
Balance
The ‘balance’ column in the amortization schedule indicates the remaining balance on the loan after each monthly or annual payment. The loan balance presented at the start of the loan is the total loan amount, which gradually decreases until it reaches zero.
Amortized and Unamortized Loans
Amortized loans allow the borrowers to pay off the loans in fixed monthly payments until the loan matures and the loan balance reduces to zero. This means the loan is fully amortized at the end of the term. During the initial years of an amortized loan, the borrower has to pay small amounts of principal; these payments increase till the later stages of the loan arrive. On the other hand, interest payments are highest at the start and gradually decrease as the remaining loan balance decreases.
Unamortized loans are those loans that don’t require payments toward the principal. The borrower makes interest-only payments as monthly payments throughout the loan term. As the end of the loan comes near, the borrower has to make a balloon payment that pays off the entire debt in a single payment. Unamortized loans are not a good option if the home buyer is looking forward to building equity in their home. However, these loans can benefit those who wish to live on a property and benefit from low payments throughout the term.
Amortization Examples
Suppose Kate takes out a mortgage to purchase a home. She qualifies for a mortgage of $250,000 to purchase the home. The following are the details for this mortgage:
- Mortgage: $275,000
- Interest: 6.7%
- Term: 10 years (120 months)
The annual amortization schedule for this mortgage is as follows. As you can see that the principal and interest payments change every year, but the total annual payment is fixed. The monthly payment is fixed, that is, $3,150.63, but in this amortization schedule, we have calculated the yearly amortization of the mortgage. The mortgage balance decreases every year, and when the loan matures, no amount remains at the end of ten years. This mortgage starts in Dec 2022; thus, the first year shows the details for one month. The remaining payments indicate yearly payments till 2032 when the loan matures.
| Year (Period) | Principal | Interest | Total Payment | Balance |
| 2022 | $1,615.21 | $1,535.42 | $3,150.63 | $273,384.79 |
| 2023 | $20,100.59 | $17,706.97 | $37,807.56 | $253,284.20 |
| 2024 | $21,489.46 | $16,318.10 | $37,807.56 | $231,794.74 |
| 2025 | $22,974.31 | $14,833.25 | $37,807.56 | $208,820.43 |
| 2026 | $24,561.75 | $13,245.81 | $37,807.56 | $184,258.68 |
| 2027 | $26,258.85 | $11,548.71 | $37,807.56 | $157,999.83 |
| 2028 | $28,073.24 | $9,734.32 | $37,807.56 | $129,926.59 |
| 2029 | $30,013.00 | $7,794.56 | $37,807.56 | $99,913.59 |
| 2030 | $32,086.79 | $5,720.77 | $37,807.56 | $67,826.80 |
| 2031 | $34,303.88 | $3,503.68 | $37,807.56 | $33,522.92 |
| 2032 | $33,522.92 | $1,133.43 | $34,656.35 | $0.00 |
| Totals | $275,000 | $103,075.02 | $378,075.02 |
Frequently Asked Questions
What is Negative Amortization?
Negative amortization refers to the increase in debt even when the borrower makes the payments on time. This situation arises when the interest is greater than the monthly payment, which results in negative amortization. Negative amortization can be harmful with credit cards as the interest rates can be very high, up to 20% to 30%. Thus, paying off the debt on a credit card as quickly as possible is important.
How to Get an Amortization Schedule?
The lender provides an amortization schedule when the borrower closes on the loan. A bank or credit union provides this loan to the borrower. Besides this, the borrower can also use a mortgage calculator to see the amortization schedule. An online calculator tool is a helpful tool for determining the monthly payments and the repayment structure of the loan.
How to Use an Amortization Calculator?
To use an amortization calculator, the borrower must input the main details of the loan. For instance, the borrower must enter the loan amount, the loan term, and the interest rate. These are the three main factors that are required to calculate amortization.
What are the Benefits of an Amortizing Loan?
Amortized loans help predict the monthly payments and the overall budget and cash flows for the long term. These loans are also helpful in a way that they have a principal component in every payment, which helps reduce the loan amount. Since the loan balance reduces every month, an amortized loan proves beneficial for those with a stable income.
What are the Drawbacks of an Amortizing Loan?
The main disadvantage of amortized loans is that a very small amount of principal is paid during the initial years of the loan and most of the payment goes towards interest. This means that the borrower can have a very small share in the property’s equity because of small principal payments. This is a drawback for those borrowers who wish to sell the home within a few years after the purchase.
What to Know for the Real Estate Exam
Amortization is the process of paying off the debt through monthly payments on interest and principal during the loan term. The process reduces the loan payment until no balance remains by the end of the term. Higher monthly payments go towards interest in the amortization schedule, but a greater portion of the loan goes toward the principal payment as the year’s increase. An amortization schedule shows periodic payments of the loan in a table form. The amortization technique is useful for determining the loan’s monthly payments and overall repayment structure. To clear your real estate exam, learn more about Real Estate Definitions.
