First-time home buyers are often daunted by the new vocabulary words they are faced with throughout the home buying process. Terms such as “earnest money”, “principal,” “due diligence,” and “equity,” are often unfamiliar concepts which need to be researched and reviewed for better understanding. One such term that borrowers should learn to comprehend early on is mortgage (or loan) amortization.
Mortgage amortization is a chart, table or schedule that records each payment on a home loan. The term “amortization” denotes the process of paying off the debt over time through regular payments. A portion of each payment is for interest while the remaining is applied towards what’s known as the principal balance – that is the amount that you actually owe on the loan, outside of the interest. The percentage of interest versus principal in each payment is determined in an amortization schedule. When you examine the amortization schedule of your loan, you can find out the actual amounts of interest and principal. Along with the part applied to the principal, another portion also goes towards paying off the interest on your loan. Typically, most loans start off with more of each payment going toward the interest, which is why it may seem like you are not getting ahead with paying off the principal during the early years of homeownership.
Each month, as you pay your mortgage, you are building equity and increasing your net worth. Look at equity as the value of the property that you own or what you have paid off each month. In addition to your home’s equity, it is also combined with the amount of appreciation, or the amount that your property gains in value over time.
Sound a little confusing? Let’s break it down even further to help you get a more accurate idea of how amortization works:
Each and every mortgage payment you make to your lender is comprised of two main components:
If you decided to pay your property taxes and homeowners insurance through escrow, then your mortgage payment will be made up of four components:
This type of arrangement is often referred to as PITI, an acronym that stand for the four components of principal, interest, tax and insurance.
The first mortgage payment you make to your lender (let’s just say it’s $500 as an example) will mostly go toward your interest balance on the loan. The breakdown may look something like this (but remember, this is just an example for illustrative purposes):
Payment #1 – $500
- $450 toward interest
- $50 toward principal
As you continue to make mortgage payments, the percentage of your payment that goes toward interest will decrease while the percentage of your payment that goes toward your principal balance will increase. For example, a payment made four years later might look more like this:
Payment #25 – $500
- $350 toward interest
- $150 toward principal
As you can see, the ratio of interest to principal for each payment has changed, but the actual payment amount has not. The principal you have now paid is still only a small amount and, therefore, the interest owed continues to dominate your payment. However, as you pay back the loan month after month, year after year, that portion of principal you have paid increases and the amount of money you owe decreases. So it goes on throughout the life of your mortgage.
The Tax Benefit of Paying More Toward Interest
Under current tax law, there’s a silver lining due to the fact that the interest paid on a primary mortgage may be tax deductible if itemized on your tax return*. Points that are paid to lower the interest rate may also be deductible*.
An excellent exercise for gaining further understanding of mortgage amortization is to enter your mortgage financing details into an online amortization schedule calculator. That should help you see and understand the details of the two repayment components. It also provides a clear picture as to why the interest repayment is high initially and then becomes smaller with every on-time payment made.
Visit our Mortgage Education Center for more information on the home buying process.
* Consult a tax professional for details.
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