How does mortgage amortization really work?
A fixed rate loan can also be referred to as a fixed payment loan – However, the amount of principal and interest paid changes with each payment.
Interest Paid – The math behind “amortization” or paying a loan off in a fixed period of time starts with the amount of interest that is earned by the lender. This is based upon the rate and principal amount of the loan. Example: $200,000 X 5.00% = $10,000 per year of interest paid
Periodic Payments – Most loans are paid on a monthly basis. If we used the example above and divided the annual interest expense of $10,000 by 12 months, we get $833.33. However, the amount of interest paid each month declines.
Principal Reduction – Each payment also includes a principal portion, which reduces the loan balance. As the balance falls, the amount of interest that’s due with each payment also goes down. Because the monthly payment stays the same, there’s more money left each month to add toward the balance. More principal paid = less interest due, less interest due = more principal paid.
When lenders collect more interest in the early years of a loan, they are only collecting what’s earned as it’s earned. The amortization allows the monthly payments to remain the same throughout the life of the loan. A borrower can always pay extra toward the principal both to shorten the loan term and reduce the total amount of interest paid.
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