What is mortgage amortization, and how is it calculated?
First time home buyers, and even seasoned homeowners, regularly obtain loans in order to facilitate real property purchases. Indeed, according to Zillow, in 2021, the average value of real property in California is over $600,000. Many Californians do not have that much cash on hand to sink into a property, or even a fraction of that. Further, many people financing a residential real property purchase are neophytes to the mortgage process. Many buyers of real property have heard terms like “amortization”, “interest”, and “principal” but do not understand the concepts individually, let alone how they interact with one another. In this blog post, we will define the basic terminology of mortgage amortization and discuss how it is calculated.
“Amortization” means paying off debt over a period of time in equal payments. Definition aside, Amortization may be best understood by example. Imagine a homebuyer (“borrower”) wants to purchase a parcel of residential real property that is on the market for $1,000,000. The Borrower has $200,000 in cash to pay the traditional “20% down” but the borrower needs to finance the rest. Accordingly, the borrower needs to obtain a loan for $800,000. Does this mean that the borrower will only need to pay the bank back $800,000?
It does not. The $800,000 the borrower borrowed from the lender is the “principal” of the loan. However, lenders do not work for free. In exchange for the principal, the lender requires the borrower to pay “interest”. Interest rates can be either “fixed”, or “variable” (aka “fluctuating”). A “fixed” rate means that the rate does not change throughout the duration of the mortgage. Alternatively, a “variable” rate fluctuates over the duration of the mortgage based on a pre-negotiated benchmark or index. For the purpose of this blog, we will focus on “fixed” interest rates.
Accordingly, the borrower must pay back both the principal and the interest. However, in a traditional mortgage, this money is not due all at once. Instead, it is “amortized” and spread over the life of the loan. To that end, the life of the loan can vary and is something the borrower can negotiate with a lender when obtaining the loan. A common length, also called a “term”, of a mortgage is 30 years. However, mortgages regularly have shorter terms, for example 15 years. Once the lender and borrower agree on the principal, term, and interest rate, the lender often prepares what is called an “Amortization Schedule”.
An Amortization Schedule is a chart used by a lender to show a borrower how much the borrower will have to pay off each month for the life of the loan. Further, an Amortization Schedule breaks down each monthly payment into two categories: principal and interest. Generally, a lender will front-load the interest portion. That way, in the beginning of the term the borrower will primarily pay the interest and at the end of the term, the borrower will primarily pay the principal.
This is easier understood by going further into our example. Imagine that the borrower of the $800,000 loan negotiates with the lender for a 4% interest rate and a 30-year term. Over the course of the loan, the borrower will pay the lender a total of $1,374,956. Divided by 30 years, the borrower will have to repay the lender just over $3,800 per month. Broken down, for the first few years, the monthly $3,800 payments may be comprised of $2,600 towards interest and $1,200 towards principal. Here, the borrower is paying significantly more interest than principal. The corollary is that in the last few years of the term, when borrower has paid off most of the interest, the borrower’s $3,800 monthly payments may be comprised of $500 towards the interest and $3,300 towards the principal.
Luckily, a borrower does not need to be a math wizard to calculate the mortgage payments and interest. Nor does a borrower need to have an “in” with a financial institution to see how an Amortization Schedule works. There are plenty of online resources, such as Bankrate that provide free and easy to use mortgage interest and amortization calculators.
Unfortunately, mortgage issues can be a lot more complex than simply calculating mortgage interest or generating a mortgage amortization schedule. There are many complex legal issues that arise involving mortgages. The attorneys at Schorr Law have years of experience representing clients in mortgage-related issues. Contact Schorr Law to schedule a consultation regarding your mortgage dispute today.