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How Does Mortgage Amortization Work?

When it comes to mortgages, amortization ensures that the borrowed amount gets repaid in equal and unchanging installments throughout the whole period. Both fixed and variable rate mortgages typically have amortization periods of 15 or 30 years.

How Amortization Affects Principal and Interest Payments

Amortized payments always contain a blend of principal and interest. Over time, more and more of your mortgage payment will go towards reducing principal rather than paying interest. This graph illustrates the payments on a 30-year fixed rate mortgage at 4% interest and an initial loan of $200,000.

YearAnnual PrincipalAnnual InterestAnnual P+IMortgage Balance
1$3,522.07 $7,935.89 $11,457.97 $196,477.93
2$3,665.57 $7,792.40 $11,457.97 $192,812.36
3$3,814.91 $7,643.06 $11,457.97 $188,997.45
4$3,970.33 $7,487.63 $11,457.97 $185,027.12
5$4,132.09 $7,325.88 $11,457.97 $180,895.03
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26$9,558.08 $1,899.89 $11,457.97 $42,288.33
27$9,947.49 $1,510.48 $11,457.97 $32,340.84
28$10,352.77 $1,105.20 $11,457.97 $21,988.08
29$10,774.55 $683.41 $11,457.97 $11,213.53
30$11,213.53 $244.44 $11,457.97 $0.00
TOTAL$200,000.00 $143,739.01 $343,739.01

Until you reach Year 14, the payments you make on a 4% mortgage will mostly go into interest expenses. Eventually, more of each monthly payment can go into paying back the principal, even while the total payment remains the same. Amortization means that mortgage payments are calculated so that the principal balance will reach zero once the final month is paid. For 30-year mortgages this process takes place over the course of 360 equal payments, while 15-year mortgages are repaid in 180 payments.

Amortizing Adjustable Rate Mortgages

Figuring out amortized payments on an adjustable rate mortgage (ARM) is slightly more complex than it is for a fixed rate mortgage. Basically, the amortization schedule must be recalculated every time the interest rate moves up or down. Most ARMs allow for rate adjustments once per year, depending on the behavior of the index rate that was chosen as a benchmark for the mortgage.

YearRateLoan BalanceMonthly Payment
1-54.00%$200,000$954.83
63.18%$180,500$874.86
73.47%$175,687$901.74
83.84%$170,906$935.45
93.62%$166,149$916.05
104.15%$161,113$961.33

For example, a 5/1 ARM might start with a rate of 4% but adjust annually after the first 5 years of payments. For each year the rate changes, you must calculate a new amortization schedule to divide up the remaining balance into the number of remaining payments. Since most 5/1 ARMs are set to pay off in 30 years, the first adjustment would require you to figure out payments for a 25-year mortgage with the new rate.

Mortgage Amortization With PMI and Taxes

Amortization schedules are not affected by private mortgage insurance (PMI) and property taxes, but these added expenses will affect how much house you can afford to buy. The more you pay in servicing costs like premiums and tax, the less you'll have available to repay your actual loan. Calculating those items beforehand can help you estimate how much you'll have left over for the amortized payments of principal and interest.

Mortgage insurance and property taxes are typically a prorated charge based on your loan amount or your property value. Annual mortgage insurance premiums are usually between 0.50% to 1.00% of your original principal —that's $500 to $1,000 a year on loans of $100,000. Property taxes depend on local rates and the latest tax assessed value of your home, both of which are determined by your county or city government. Property taxes allow deductions for primary dwellings, veterans, seniors and other demographic categories.

How Extra Payments Affect Mortgage Amortization

Paying extra amounts to reduce your principal ahead of schedule can help you pay off your mortgage faster and reduce the total cost of interest. For instance, consider a 30-year mortgage for $200,000 at a fixed rate of 4%. If you paid an extra $200 towards your principal every 3 months, you would shave almost 2 years off your amortization schedule and save $19,000 in interest payments.

If you're in a standard fixed rate mortgage, extra principal payments won't reduce your monthly payments. Still, they will help you gain full ownership of the property more quickly. In contrast, extra payments on an adjustable rate mortgage can reduce your monthly payments —but only at times when the lender adjusts your rate and recalculates your amortization schedule. If you plan on making extra payments, this may be an important factor in choosing an adjustable rate mortgage over the usual fixed rate mortgage.

However, using extra payments to save money can backfire if your mortgage carries any prepayment penalties. Smaller mortgage lenders often limit the amount of principal you can repay each year, charging a fine if you exceed that limit. This ensures that the lender earns a profit even if the mortgage is ended early with a sale or refinance. Prepayment penalties are usually charged as six months' worth of interest on the current balance of the mortgage.

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