What Does it Mean to Amortize a Loan?

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Few home buyers have the upfront cash collateral to purchase a home in full. More often, a home buyer must take out a mortgage, a type of loan especially for home purchases. The buyer repays the loan amount in gradual installments over a pre-set amount of time. In return for the loan, the lender, usually a bank or similar financial institution, charges the borrower interest, or a small percentage of the total loan amount. Calculating the borrower's monthly payment to include interest owed is called loan amortization.

Definition

A mortgage lender amortizes a loan by dividing up the amount the borrower owes into a series of equal payment installments. The borrower gradually pays the installments over a predetermined period of time. Any payments she makes go toward paying down the principal loan amount, as well as paying off any interest she owes the lender.

Mortgages commonly have repayment terms of 15 or 30 years, but the terms of a mortgage loan can be longer or shorter than that. At the end of that time, the borrower will have paid off the loan in full, along with all interest owed. When the borrower has made the last of the amortized payments, he will fully own his home. The longer a mortgage term is, the more interest a borrower pays in relation to the principle loan amount.

How Loan Amortization Works

When a borrower takes out a mortgage, she agrees to pay the lender back for the loan, along with a certain percentage of interest each year. The percentage amount is determined annually; however, the interest is calculated monthly based on the remaining loan amount. For example, a borrower has a mortgage loan of $200,000 with an annual interest rate of 12 percent. This means the borrower must pay interest on the loan each month at the rate of 1 percent per month. In the first month, the borrower will owe $2,000 in interest. If the total payment to the lender is $3000, only $1,000 of that payment will go toward paying down the original loan, bringing the principal outstanding balance to 199,000. The next month, the borrower will owe $1,990 in interest, and $1,010 of his $3,000 payment will go toward paying down his original loan, bringing his balance down to $197,900. This process goes on each month until the borrower has paid off the original loan in full.

Effects on Equity

The majority of a borrower's payments in the beginning of the mortgage term go toward paying interest. As the principal loan amount decreases with the borrower's payments, so does the amount of interest the borrower owes. The monthly payment amounts, however, remain the same, so that, gradually, more and more of the borrower's payments go toward paying down the principal loan over the life of the loan.

Some lenders allow borrowers to reduce the amount of interest they must pay by allowing them to make larger than minimum payments. The additional amount in the payment goes directly toward paying down the principal loan amount.

Still other lenders have programs that allow borrowers to pay half the monthly amount every other week, instead of making one payment monthly. Over the course of a year, a borrower makes 13 full payments instead of 12. In this type of program, a borrower can pay off the total loan amount faster and reduce the total amount of interest paid over the life of the loan. You can use a loan amortization calculator to figure out the impact larger monthly payments may have on your mortgage debt.

Impact on Borrowers

Because of how loan amortization works, the longer a borrower makes payments on her mortgage loan, the more equity she has. This means that the longer she makes payments, the greater her share is in her investment. Borrowers must make many years of regular payments in order to reduce the principal loan amount in a significant way.

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