Definition
Amortization refers to the process of gradually paying off a loan over time through scheduled payments that include both principal (the original loan amount) and interest (the cost of borrowing). In real estate, amortization applies to mortgage loans, which are typically structured so that payments remain consistent over the loan term, even as the balance decreases.
Explanation
Mortgage amortization follows a payment schedule, where a portion of each monthly payment goes toward interest first, while a smaller portion reduces the principal balance. Over time, as the loan balance decreases, more of the payment is applied to the principal and less to interest. This ensures that by the end of the loan term (often 15, 20, or 30 years), the mortgage is fully repaid.
A mortgage amortization schedule outlines the breakdown of payments over time, showing how much goes toward interest versus principal each month. Borrowers can also make extra principal payments to reduce the total interest paid and shorten the loan term.
Example
A homebuyer takes out a $300,000 mortgage with a 30-year fixed rate at 4% interest. Their monthly payment (excluding taxes and insurance) is about $1,432.
- In the first year, most of their monthly payment goes toward interest rather than reducing the loan balance.
- By year 15, the balance is lower, so a greater portion of each payment is applied toward the principal instead of interest.
- By the end of year 30, the loan is fully paid off.
If the homeowner makes extra payments toward the principal, they can reduce the interest owed and pay off the loan sooner.