What is Amortization?
Real Estate Terms and Definitions:
Quick Definition: A method of equalizing the monthly mortgage payment over the life of the loan by adjusting the proportion of principal to interest over time. At first, the interest payment is high and the principal payment is low. At the end of the loan, interest payments are low and principal payments are high.
In-Depth Explanation of Amortization
Amortization is the way lenders make your monthly payments on your home loan predictable. Home owners want to know what their monthly expenses will be when they own a home, so making monthly payments equal and predictable helps them to manage their finances and plan for the future.
When a mortgage is first taken out, whether through a refinance or a home purchase, the balance of the loan is at its highest point. That means the amount of interest to be paid on the loan is also at its highest point. The lender could skip amortization of the loan, and just make the loan payments include equal portions of the principal balance.
A 30 year mortgage has 360 monthly payments. If a borrower took out a $360,000 mortgage to buy a home, and it was not amortized, each month the payment would include $1,000 in principal paydown, plus the interest due on the balance.
The mortgage payments would change every month without amortization.
Here is an over-simplified example:
Mortgage balance: $360,000
Interest rate: 4.0 percent
First month's payment: $1,000 principal plus interest on $360,000 ($1200)
Total first month's payment: $2,200.
The payment would go down every month.
Second month's payment: $1,000 principal plus interest on $359,000: ($1196.67)
Total second month's payment: $2,196.67
Regular monthly payments, if you had amortized the loan:
$1,718.70/mo for 30 years
As you can see, it would quickly become a hassle to pay a different amount each month. Amortization fixes this problem by only paying a small portion of the principal balance at the beginning of the loan term, and a large portion at the end. This way, the payments balance with the large interest portion of the payment at the beginning, and the small interest portion at the end. All the while, your monthly mortgage payment of principal and interest remains the same.
How Amortization could affect your real estate transaction:
The amortization of your loan might not seem particularly relevant to the transaction itself, but obviously it affects your ability to finance a home. Your pre-approval letter will be critical to your offer, and the size of loan you're approved for affects the kind of home you can buy. Amortization is a part of this.
Since amortization actually makes your initial payment less than it would be if you paid equal shares of principal throughout your loan term, you can qualify for a larger loan, and a more expensive home, with an amortized loan. Your monthly payment, being lower at the beginning and standardized throughout the loan, gives you more buying power.
So, it wouldn't necessarily wrong to say that amortization got you into that better neighborhood, that upgraded kitchen, or that golf course view. Lenders like predictability, and amortization is one way that they can trust your ability to continue to pay for your home, and you can comfortably plan for your future.
Want to know more about amortization?
This post is for informational purposes only, home buyers and sellers should not rely upon it to make decisions. Consult with a licensed real estate broker and/or real estate attorney before making real estate related decisions.
We have real estate brokers, mortgage lenders, inspectors, title officers, and others who can answer your real estate-related questions. Give us a call or send us an email and we can put you in touch with someone who can answer your amortization questions or any other questions about home buying, selling, and the real estate world.
Your amortized mortgage will make your planning and budgeting predictable, and help guide you to the right home at the right price. Let us help you find that right number for a monthly payment and a home price to make your home buying process easier.
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Sam DeBord is Managing Broker with Seattle Homes Group and Coldwell Banker Danforth. Our team serves home buyers and sellers in Seattle, on the Eastside, and across the Puget Sound Region.
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