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One of the biggest advantages of homeownership versus renting is each mortgage payment gradually pays off your mortgage and builds equity in your home. The difference between your home’s value and the balance of your loan is home equity, and your equity grows with each payment because of mortgage amortization.
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What is mortgage amortization?
Mortgage amortization is the process of paying off your loan balance in equal installments over a set period. The interest you pay is based on the balance of your loan (your principal). When you begin your payment schedule, you pay much more interest than principal.
As time goes on, you eventually pay more principal than interest — until your loan is paid off.
How mortgage amortization works
Understanding mortgage amortization starts with how monthly mortgage payments are applied each month to the principal and interest owed on your mortgage. There are two calculations that occur every month.
The first involves how much interest you’ll need to pay. This is based on the amount you borrowed when you took out your loan. It is adjusted each month as your balance drops from the payments you make.
The second calculation is how much principal you are paying. It is based on the interest rate you locked in and agreed to repay over a set period (the most popular being 30 years).
If you’re a math whiz, here’s how the formula looks before you start inputting numbers.
Fortunately, mortgage calculators do all the heavy mathematical lifting for you. The graphic below shows the difference between the first year and 15th year of principal and interest payments on a 30-year fixed loan of $200,000 at a rate of 4.375%.
For the first year, the amount of interest that is paid is more than double the principal, slowly dropping as the principal balance drops. However, by the 15th year, principal payments outpace interest, and you start building equity at a much more rapid pace.
How understanding mortgage amortization can help financially
An important aspect of mortgage amortization is that you can change the total amount of interest you pay — or how fast you pay down the balance — by making extra payments over the life of the loan or refinancing to a lower rate or term. You aren’t obligated to follow the 30-year schedule laid out in your amortization schedule.
Here are some financial objectives, using LendingTree mortgage calculators, that you can accomplish with mortgage amortization. (Note that MagnifyMoney is owned by LendingTree.)
Lower rate can save thousands in interest
If mortgage rates have dropped since you purchased your home, you might consider refinancing. Some financial advisors may recommend refinancing only if you can save 1% on your rate. However, this may not be good advice if you plan on staying in your home for a long time. The example below shows the monthly savings from 5% to 4.5% on a $200,000, 30-year fixed loan, assuming you closed on your current loan in January 2019.
Assuming you took out the mortgage in January 2019 at 5%, refinancing to a rate of 4.5% only saves $69 a month. However, over 30 years, the total savings is $68,364 in interest. If you’re living in your forever home, that half-percent savings adds up significantly.
Extra payment can help build equity, pay off loan faster
The amount of interest you pay every month on a loan is a direct result of your loan balance. If you reduce your loan balance with even one extra lump-sum payment in a given month, you’ll reduce the long-term interest. The graphic below shows how much you’d save by paying an extra $50 a month on a $200,000 30-year fixed loan with an interest rate of 4.375%.
Amortization schedule tells when PMI will drop off
If you weren’t able to make a 20% down payment when you purchased your home, you may be paying mortgage insurance. Mortgage insurance protects a lender against losses if you default, and private mortgage insurance (PMI) is the most common type.
PMI automatically drops off once your total loan divided by your property’s value (also known as your loan-to-value ratio, or LTV) reaches 78%. You can 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.
Find the balance on your amortization schedule and you’ll know when your monthly payment will drop as a result of the PMI cancellation.
Pinpoint when adjustable-rate-mortgage payment will rise
Adjustable-rate mortgages (ARMs) are a great tool to save money for a set period as long as you have a strategy to refinance or sell the home before the initial fixed period ends. However, sometimes life happens and you end up staying in a home longer than expected.
Knowing when and how much your payments could potentially increase, as well as how much extra interest you’ll be paying if the rate does increase, can help you weigh whether you really want to take a risk on an ARM loan.