Amortization is when you take your debt and make a payment schedule, calculating each payment amount until it’s paid off entirely. This is usually in reference to any type of a loan that has added interest.
What Exactly is Amortization?
To “amortize” literally means “to kill it off”, so this term is specifically for those who are paying off their debt in the form of fixed payments. Amortization can be used for large expenses in business, but with the same concept in that it’s done in increments. For example, a business will make a large investment that is expected to bring in a large ROI (return on investment) over several years. Businesses will write off the expense incrementally over years instead of writing off such a large investment purchase all at once. More commonly, amortization is also used for loans such as student loans, home mortgages, auto loans, etc.
If you’re looking to see what your monthly payment will be if you borrow a certain amount, there are many resources online that are free. All you have to do is input the principal (the amount that you are borrowing/want to borrow), the interest rate, and how many payments. Different mortgage types have different term lengths, but since amortization only applies to fixed interest rate mortgages, it will most likely be 15 or 30 years unless you and the lender decided on a different term. Once you enter all of this information, you can see how much each payment will be. You will also get a breakdown of how much of each payment will go towards the principal and the interest.
You’ll see that for the earlier payments, the majority of your monthly payments are going to interest. When deciding between a 15-year fixed and a 30-year fixed, you’ll see that a shorter term will result in building equity much faster. With a 30-year fixed, the first 12 years’ monthly payments have the majority of the payment amount going to interest.
Why Does My Math Look Wrong?
If you’re going to be paying the same amount every single month until the loan is paid off and the interest rate is fixed, why is there a need for a fancy formula (yes, there’s a formula to calculate each payment)? You could easily get the interest rate, multiply that by the principal, add that amount to the principal and divide it by the amount of payments, right? Wrong.
The reason why that isn’t the case, is because with amortization the interest rate isn’t for the entire loan. The interest rate is actually the monthly rate. When you take the interest rate and divide it by 12 (for the amount of months there are in a year) and multiply it by the principal, the total interest you pay will be more.
Yes, it is ideal that everyone can buy homes in cash and in full, but it isn’t common. Most people don’t have that kind of money lying around. Thankfully, mortgages allow us to purchase homes and pay it off in installments. Paying a lot in interest isn’t ideal, but sometimes having property to call your own is worth it. If it’s something that you can afford, getting a mortgage with a short term would be best because you pay significantly less in interest.