You are in the middle of the home buying process and everything is new and exciting and a little confusing. You get the process, so to speak: you find a dream house, make a down payment and borrow the rest. Then – in just 30 years or 360 monthly payments – this dream house is entirely yours.
It all sounds so simple until your lender or real estate agent mentions "Payback". Don't feel left out: for many of us, buying a home (or a car) was also the first time we heard the word. Even if you didn't have to reach for a dictionary or thesaurus, we recommend reading on. Hopefully this blog will help you understand what amortization is and how it works in paying off your home loan.
What exactly is amortization?
A monthly mortgage payment basically consists of two things:
- The principal is the amount of money you need to borrow to buy the house – minus the down payment
- The interest, i.e. H. the amount the lender charges to borrow the principal.
To break it down, amortization is simply a way to settle your monthly mortgage payment over the life of the loan. Over time, the payback adjusts the ratio of the principal paid to the interest paid.
When you start paying off your mortgage, the interest payment is high and the amortization is low. As you near the end of the loan, the opposite happens: the interest payments are low and the principal payments are high.
Amortization makes the monthly payments of a home loan equal and more predictable, which can help homeowners better manage their finances, plan for expenses like a new car or a child's education, and set aside something for emergencies or extravaganzas like a well-deserved vacation. Without amortization, your monthly mortgage payments could be anywhere on the card every month.
How does the amortization work?
The first time you take out a home loan, whether you're buying a home or refinancing an existing mortgage, the loan balance is at its peak. This means that the interest you owe on the entire loan is higher than ever before.
In theory, your lender could skip the amortization and make sure that the loan payments contain equal parts of the principal balance. But paying a different amount each month would quickly become a budget problem.
What if you didn't have a payback?
Let's say you want to get an offer on a house. Your lender suggests that the best mortgage for you is a 30 year fixed rate mortgage. With 12 monthly payments per year, that would be 360 monthly payments.
To make the math easier in this example, let's say the offer you make is $ 400,000 and you put down 10%, or $ 40,000. To buy the home, you will need to borrow $ 360,000
Now let's assume that the $ 360,000 mortgage has not been amortized. Each of the 360 monthly amounts would consist of a principal return of $ 1,000 plus interest on the balance. Since the principal would decrease by $ 1000 after each payment, your interest rates will change every month.
- Payment for the first month includes interest on the entire $ 360,000.
- For your second month, you pay interest on $ 359,000.
- Your third would be $ 358,000 and so on.
As you can imagine, at the start of the mortgage repayment process, you have much larger payments that you may not be able to afford. Compare that to halfway through when you're only left with half the original amount or $ 180,000 in interest. With your monthly payment constantly adjusting from month to month, it is difficult to budget for the rest of your life.
Amortization resolved uncertainty
Amortization takes this into account by setting a fixed, recurring monthly payment amount for the life of the loan, even though you pay off the interest and principal of the loan in different amounts each month. As already mentioned, the interest costs are highest early on. But as time goes on, the funds used for your principal increase while the funds used for interest keep decreasing.
In short, amortization helps keep a borrower's monthly mortgage payment the same throughout the life of the loan so that they can schedule a fixed payment structure.
Payback gives you more purchasing power
Payback may seem complex, but it will have a critical impact on your ability to get funding to buy your dream home.
First of all, a fixed, recurring payment will help your loan officer determine if you can process that payment based on your current creditworthiness and income. If the monthly payments are all over the card, he or she may lose confidence that you are making payments on time. They may be seen as more risky and may not get pre-approved. Remember, home sellers love a pre-approved listing. Pre-approvals go a long way so that your offers stand out from others.
Because the repayment makes your monthly payments less than if you paid off the principal evenly throughout the loan, you can qualify for more loans. This could open up your search for larger apartments, apartments in better condition or apartments in better neighborhoods. Essentially, the payback gives you more buying power.
Visualize your amortization
The easiest way to understand repayment is to look at a repayment table, a visual representation that lists each monthly loan payment and details how much is in either the interest or principal. If you have a mortgage, an amortization table has been attached to your loan records. If you are still in the research process, examples can be found all over the internet.
Better yet, check out NerdWallet's mortgage Payback calculator. This handy tool allows you to enter the loan amount you want, the down payment you want and a possible interest rate. It even takes your location into account so potential taxes can be accounted for. Then it spits out a breakdown of your monthly mortgage and shows what your loan amortization might look like.
Talk to us
Connect to a local mortgage loan officer. He or she will see how much you may qualify for a loan and how your monthly mortgage payments could change due to the amortization and a 30 or 15 year maturity.