What Is Amortizing a Mortgage Loan?
Lenders use amortization as a form of payment structure for mortgage loans. Different from conventional loans, amortized mortgages apply the principle and interest payments differently than traditional loans, such as car loans. Understanding how the amortization process works can help a homeowner in understanding how much equity they own in the property.
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Payment Calculations
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Mortgages come with amortization schedules that show the break-down for the individual payments. The first payments for a loan will feature a small amount towards the principle and a large amount towards the interest. The final payments on an amortized loan feature large principle payments and small interest payments. This is due to the way the loan is calculated.
For each payment, the outstanding balance of the loan is divided by the number of months of the loan. Interest is calculated on the outstanding balance and added to the loan. Every payment reduces a portion of the interest amount because the outstanding balance is going down. As the interest amount goes down, the portion of the payment added to the principle increases.
Amortized Mortgages
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Mortgages are the most frequently amortized loan. The monthly payment on a fixed-rate mortgage will remain the same every month, even though the application of the mortgage payment is changing.
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Misconceptions
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Many borrowers confuse interest-only loans with amortized loans. In interest-only loans, the entire amount of the monthly payment goes to the interest. This amount never changes on a fixed-rate loan as long as the principle is not being paid down. The borrower has the option of making a supplemental payment for the interest. After a set amount of years, the interest-only loan changes to a regular loan with an amortization schedule. Amortized loans feature payments that go to both the principle and the interest every month.
Effects of Equity
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With an amortized loan, equity builds very slowly at first. With the decrease of the interest and increase of the principle, equity builds faster during the second half of a loan. In fact, it usually takes half of a loan's term life for the principle payment and interest payment amounts to be equal.
Additional Principle Payments
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Most mortgages allow for extra principle payments at any point during the loan. The faster the balance of the loan is decreased, the smaller the interest portion of the payment each month. This allows for equity to build at a faster rate. Making additional payments on a amortized loan not only reduces the amount of interest paid over the course of the loan, it also shortens the number of payments on the loan.
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