Amortization, derived from a Latin word admortire, which means “to kill”, is a term one often hears when inquiring about mortgages.
We are sure this is quite intriguing to many of you. We felt the same way, when we heard about it the first time. But as you read on, you’ll find out what does, why and how? And in the end, it’ll all make sense.
How does a typical loan work?
Taking a loan meant borrowing money, and paying interest periodically on the amount that was borrowed. At the end of the term of the loan, the principal had to be returned.
That still continues to be the case in a large variety of loans.
For instance, when the US Government borrows money by issuing bonds, it pays interest to the bondholder every six months and upon the maturity of the bond, they pay back the original principal.
That’s how corporations who borrow money do too. Pay interest every year and pay back the principal at the end of the loan term.
Consumer loans are different
For most consumer loans, such as home loans, education loans and car loans, things are different.
Take a mortgage loan, as an example.
A typical mortgage loan entails borrowing a very large sum of money. If the loan is structured the same way as the loans above, the borrower would have to pay a big lump-sum at the very end, which can be very difficult for most people to pay all of a sudden.
To avoid that, the loan is structured such that every month, the borrower pays the interest they owe (based on the outstanding principal and the rate of interest). And, a little bit of principal owed.Loan is structured such that every month, the borrower pays the interest they owe (based on the outstanding principal and the rate of interest). And, a little bit of principal owed. Click To Tweet
The following month, the outstanding principal is reduced slightly (due to the small principal payment the previous month). So the interest for that month is reduced.
This process of paying off the principal over time is what is called Amortization.
Wait, weren’t we talking about “killing” something?
Precisely. If you think about it, by doing what we described above, the borrowers pay off their principal slowly.
In essence, they “kill” the principal balance little by little every month, like death by a thousand 360 cuts.
You see the link now?
Ok, we have an answer to “what” and “why”. What about “how”?
Well, we already know a little bit of the “how”. What still continues to intrigue some of us is the question below:
The borrower has a different amount of interest payment every month (given principal is changing every month), a different principal reduction amount every month and yet at the end of the loan term, the principal balance just magically becomes zero. And all of this, while the borrower is making exactly equal monthly payments for the duration of the loan. That sounds quite mysterious.
It’s a very apt question. How is it that there are many moving parts (i.e. principal and interest, the balance) with each month’s interest being dependent on the previous month’s principal. Yet the one thing that does not change is the monthly payment.
How is the lender able to come up with that magical monthly payment number such that all of this just works perfectly?
As long as you make an equal monthly installment payment, you are taking care of all of the following:
- Paying the interest that is owed
- Reducing the principal gradually
- Left with no principal at the end of the loan term.
What happens when you make a payment?
When you make a payment in any month, the following are the things that happen.
- Lender calculates how much interest you owe for that month (based on the interest rate and the principal balance from the previous month)
- Subtract the interest owed from the payment you made
- Whatever remains is counted as contribution towards reduction in principal balance.
- That amount is subtracted from your previous month’s principal balance to get the new balance.
When you make only scheduled payments:
The principal reduction every month will be exactly as scheduled, i.e. such that the balance becomes zero exactly at the end of the loan term.
That’s exactly the assumption that was made when you signed up.
And what happens when you pay more than required, i.e. prepay?
Based on the steps described above, whenever you pay more than the scheduled payment, the principal balance reduction that month is more than scheduled.
So the interest for every subsequent month will be lower than scheduled (because outstanding principal is lower than scheduled).
To summarize, every time you pay more than required, you are expediting your principal reduction. As a result, it will help you pay off your loan sooner than the term of the loan.
I pay more interest in the beginning. Can I pay off more principal initially instead?
The principal portion of one’s monthly payment is typically low in the beginning and increases every month.
People often think that is unfair. The question they ask is “Why can’t the lender charge me less interest in the beginning and more goes towards principal?”
As you pay down that principal over time, the interest for subsequent months is reduced.
Can I get a mortgage where I can make only interest payments?
Yes, absolutely. Quite a few lenders offer mortgages where you only have to pay the interest. But such mortgages have a few issues associated with it:
- Such mortgages typically require higher down payments (because the risk for the lender is more since the borrower has the same principal balance at the beginning).
- The interest rate offered on such mortgages is also likely to be higher (because of more risk involved).
- If the property has depreciated in value since you bought it, you will get less than the down-payment you paid in the beginning.
While amortization can initially be a difficult concept to understand, when explained in a simple manner, it is pretty straightforward.