Mortgage Amortization: What homeowners should know

There is no doubt that mortgages are a good thing. Homebuyers use mortgages to purchase real estate and current homeowners access cash using cash out refinance loans. These macro-benefits can be hard to dispute. Mortgages do have some less than desirable traits. One of these is mortgage amortization.

If this statement has you puzzled, then read on.  This information could save you time and money.

Mortgage amortization definition

Mortgage amortization is the process of paying off a mortgage balance with regularly scheduled, equal payments. To ensure a solid understanding, let's break this definition down into two parts.

"the process of paying off a mortgage loan"

The actual task of paying off a mortgage loan is similar to most other loans.  Homeowners send a check or set up a monthly draft to cover the required monthly payment. Homeowners make this payment over a period of time, called the loan term. The most common term for a mortgage today is 30 years (360 months).

Virtually all residential mortgages are paid off over several years.  Some mortgages can require full repayments, called balloon payments, at a specific point in the future. Balloon payments are not allowed for most residential mortgages, so we'll focus on a traditional full term mortgage loans.

"with regularly scheduled, equal payments"

As mentioned above, mortgage amortization is associated with a monthly repayment schedule. Mortgage payments are due on the same day each month and lenders will dictate the minimum payment required in advance.

A monthly mortgage payment is made up of several different items. Some of these, such as property taxes and homeowner insurance premiums, can change over time. [What goes into a mortgage payment?]

We will examine the portion of the mortgage payment associated with paying down the mortgage debt.  To be specific, we will evaluate mortgage interest and mortgage principal payments only.

Mortgage amortization in action

With the definition of mortgage amortization behind us, let us step into the action!  By examining a typical amortization schedule, we'll solidify our understanding and make some key discoveries.

Mortgage amortization example

For the example, we will use current data from the housing market. This will allow us to examine an amortization schedule for an average homebuyer in today's environment. Here are the numbers:

• New home purchase price*: $312,000

• Down Payment Amount**: $15,600 (5% of purchase price)

• Starting loan amount: $296,400

• Mortgage loan term: 30 years

• Mortgage Interest Rate***: 4.00%

Given this information, homeowners will pay $1,415.06 towards interest and principal each month. Next, let's examine how this payment is applied over the course of 30 years.

Mortgage amortization in the first year

Our average homeowner will make a mortgage payment in the amount of $1,415.06 each month.  (Remember that this amount does not include taxes, insurance and other potential items.)

In the first month, his payment will reduce the mortgage balance by $427.06 and pay the lender $988 in interest. The mortgage balance after the payment is $295,972.94.

Key Discovery #1:  In the first month of paying a mortgage, this homeowner reduced his mortgage balance by just $427.06, despite making a $1,415.06 payment. Nearly 70% of the payment went to the lender in the form of interest.

Over the course of the first year, the homeowner pays slightly more towards principal each month.  He also pays slightly less towards interest each month. By the end of the first year, the homeowner pays a total of $5,219.69 towards his mortgage balance.  This represents just 1/56th of his beginning loan amount.

Key Discovery #2: In the first year of a 30-year amortization schedule, 1/56th of the loan balance is paid, despite 1/30th of the 30-year loan term being completed.

To ensure this sinks in, ask yourself this question: If you obtained a 30-year mortgage, would you expect to reduce the balance by about 1/30th each year?  Seems logical, doesn't it?  Think again.

In actuality, you would not pay 1/30th of the loan in the first year. Rather, you would pay just 1/56th of the loan balance in the first year, leaving you with 98.3% of the loan to be paid in the remaining 29 years!

Let's now consider the last 12 months of this same loan's amortization schedule.

Mortgage amortization in the final year

Our homeowner has been diligent about paying his mortgage for 29 years.  With just 12 months left, he continues to pay $1,415.06 each month until the day the mortgage is gone. In this final year of the mortgage, the homeowner pays a total of $16,618.45 in principal to eliminate his mortgage completely.

Key Discovery #3:  This homeowner reduces the loan balance by 5.6% ($16,618.45) in the final year. This represents 1/18th of the balance, despite only 1/30th of the loan term being completed.

If the difference between the first year and final year hasn't jumped out at you yet, let's review the data.

First Year vs. Last Year

Comparing the first year to the final year of a 30-year mortgage amortization schedule exposes significant differences. In our example, $11,398 more is paid towards the loan balance in the final year of the amortization.  Said another way, 3.85% more of the mortgage balance is being paid down in the same one-year time period.

Mortgage amortization favors your lender

So, how does the mortgage amortization schedule favor your lender?

Lenders collect the bulk of their interest early in the mortgage term. This results in a slow mortgage balance pay down for a homeowner. In the first year example above, the homeowner paid $16,980.72****, to find only $5,219.69 went towards the principal balance.

Homeowners receive no credit for "mortgage time served." Homeowners who refinance a mortgage will find their new mortgage also starts from the same inefficient position detailed above.

Homeowners who sell and then buy a new home will experience a similar inefficiency. The first few years of mortgage payback while living in the first home will benefit the lender far more than the homeowner.

Tilting the scale in your favor

So what can be done to ensure your dollars are used efficiently?

Consider obtaining a shorter term

We evaluated the stark contrast between the first year and last year of a 30-year amortization schedule. Mortgages with shorter terms will be more efficient with respect to interest and principal payments.  They will also come with larger required monthly payments.

What if you want the benefit of a shorter term, but the flexibility to make lower payments when needed?  One option is to consider making extra payments on a 30-year mortgage term.

Consider making extra payments

Money paid in excess of the minimum monthly payment will be applied to the principal balance.  When the principal balance is reduced, future interest charges decrease.  This was the case in the examples described above, and we will examine it here one more time.

In our example, the homeowner makes his first six payments according to his amortization schedule. The 6th payment reduced his principal by $434.22 and paid interest of $980.83. He is now due for his 7th payment.

After picking up a lucrative side hustle, the homeowner decides to accelerate his mortgage payback. He reviews the amortization schedule, noting that his 7th and 8th principal payments are $435.67 and $437.12. He then adds $437.12 to his 7th mortgage payment, allowing him to skip the 8th month completely. As a result, the homeowner saves all the interest he would have paid in the 8th month: $977.94.

This is possible because a homeowner's position on the amortization schedule is determined exclusively by the remaining principal balance. Accordingly, the homeowner can continue to add money to his payments and accelerate his mortgage payoff, saving thousands in interest along the way.

Data Sources:

• ** "First-time buyers who financed their home typically financed 95 percent of their home compared to repeat buyers at 86 percent"    https://www.nar.realtor/research-and-statistics/research-reports/highlights-from-the-profile-of-home-buyers-and-sellers

• **** Yearly payment $16,980.72 = (12months x $1,415.06)

Legal Disclaimers:

• Tax implications or considerations are not included in this review

• This is for illustration purposes only - loan terms will vary for each homeowner

• This is not an offer to make a loan in any form