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Updated on Friday, March 27, 2020
The difference between your home’s value and how much you owe on your mortgage is your home equity. With each mortgage payment you make, mortgage amortization — or paying down the loan in installments — is at play, and each monthly payment brings you closer to owning your home outright.
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What is mortgage amortization?
Mortgage amortization is the process of paying off your loan balance in equal installments of principal and interest for a set time period. The interest you pay is tied to the balance of your loan (your principal) and the mortgage rate. When you first start making payments, most of the payment is applied to the interest rather than the principal.
Your principal payments catch up with interest over time until your loan is paid off. Once it reaches a zero balance, it becomes a “fully amortized loan.”
How mortgage amortization works
The easiest way to understand mortgage amortization is to look at how monthly mortgage payments are applied to the principal and interest on an amortization table. There are two calculations that occur every month.
- The first calculation measures how much interest is paid based on the rate you agreed to. The interest charge is recalculated each month as you pay down the balance, and you pay less interest over time.
- The second calculation reflects how much of the principal you pay. As the loan balance shrinks, more of your monthly payment is applied to your principal.
If you’re a math whiz, here’s the formula:
A mortgage amortization calculator does the heavy lifting for you. You can see the effects of amortization on a 30-year fixed loan amount of $200,000 at a rate of 4.375% below.
In the first year, you pay more than twice as much toward interest as you do toward the principal. However, the balance slowly drops with each additional payment. By the 15th year, principal payments outpace interest and equity starts building at a much faster pace.
How mortgage amortization can help with financial planning
A mortgage amortization table helps you assess the short- and long-term benefits of adjusting your mortgage payments. Making extra payments over the life of the loan or refinancing to a lower interest rate or term could save you thousands in interest charges over the life loan. Even better: you’ll end up with a mortgage free home sooner.
Using a mortgage calculator to configure a few scenarios, here are some financial goals you might be able to accomplish using mortgage amortization.
Calculate how much money you can save by refinancing
If mortgage rates have dropped since you bought your home, consider refinancing. If you’re in your forever home and don’t plan to move for a while, a half-percentage point drop in rates could make room in your budget to boost retirement savings, your emergency fund or put money toward other long-term financial goals.
The example below shows the monthly payment and lifetime interest savings if you replaced a 30-year, fixed-rate loan for $200,000 at 4% with a new loan with a 3.5% interest rate with the same terms.
While saving $56.74 per month on payments doesn’t seem like much, it adds up to $20,426.83 in interest savings over the loan’s lifetime.
See the effect of making extra payments
The amount of interest you pay every month is directly connected to your loan balance. Even a small amount added to the principal each month reduces interest over time. The graphic below shows how much you’d save adding an extra $50 every month to your payment on a $200,000, 30-year fixed loan with an interest rate of 4.375%.
Figure out when you can get rid of PMI
Borrowers who don’t make a 20% down payment on a conventional mortgage typically pay for private mortgage insurance (PMI). The coverage protects a lender against financial losses if you don’t repay the loan.
Once your loan-to-value ratio, or the loan balance in relation to the home’s value, reaches 78%, PMI automatically drops off. Multiply the price you paid for your home by 0.78 to determine where your loan balance would need to be for PMI to be canceled. Locate that balance on your loan payment schedule for a rough idea of the month and year PMI will end.
Decide if it’s time to refinance an adjustable-rate mortgage
Adjustable-rate mortgages (ARMs) are a helpful tool to save money on monthly mortgage payments. However, ARMs make more sense if you plan to refinance the loan or sell your home before the initial fixed-rate period ends and the loan resets to a variable interest rate.
An adjustable-rate mortgage amortization schedule helps you pinpoint when the loan will reset and gives you an idea of the worst-case scenario on payments. If the adjustments are outside of your comfort zone, consider refinancing your ARM into a fixed-rate mortgage.
The difference between a 15-year fixed and 30-year fixed payment schedule
Refinancing to a shorter term, such as a 15-year fixed mortgage, may save you hundreds of thousands of dollars over the life of a loan — but the trade-off is a higher monthly payment.
The graphs below show the difference between a 30-year amortization schedule for a $200,000, fixed-rate loan at 4.375% and a 15-year amortization schedule for the same loan amount at 3.875%.
The lifetime interest savings for a shorter loan payment schedule is $95,447.16. As long as the $468.31 increase in your mortgage payment doesn’t prevent you from meeting other savings or investment goals, the long-term savings are worth it.