What is mortgage amortization?

An amortized loan is a type of loan that involves making every payment according to the original loan amortization schedule and paying it off by the end of the term. The term “amortization” itself simply refers to the amount of principal and interest paid each month over the course of the loan term.

Near the beginning of the loan, most payments are applied toward interest. Over time, the balance shifts so that by the end of the term, nearly the entire payment is applied to paying off the principle of the loan. You’ll find this model of repayment in home loans, auto loans, and personal loans from banks.

The interest on an amortized loan is based on the most recent ending balance of the loan. As you make payments, the interest amount decreases and the principal portion increases. The way to calculate this is to multiply the balance of the loan amount by the interest rate in the current period (or divide an annual interest rate by 12 to find a monthly rate). Subtract the interest due for the period from the total monthly payment, and you’ll arrive at the dollar amount of principal to pay for the period. 

 The principal is applied to the balance of the loan. Subtract the principal paid in the period from the current balance of the loan, and you’ll see the new outstanding balance. This outstanding balance is what sets the interest for the next period. Amortized loans are structured differently, however, for fixed-rate and variable-rate mortgages.

As the name suggests, a fixed-rate mortgage doesn’t fluctuate with the market. In other words, the interest rate on a fixed-rate mortgage doesn’t move regardless of whether interest rates are rising or falling. The only variable is the amount of principal and interest you’ll pay each month. 

At the beginning of the loan, that balance is weighted toward interest, and over time, you’ll pay more toward the principal. The interest rates for 15-year loans are lower than those for 30-year loans, so combined with a shorter timeline, borrowers will pay less in interest overall and build equity faster. The difference is that monthly payments will be larger than with a 30-year mortgage. 

On an adjustable-rate mortgage, or ARM, your interest rate can go up or down at the end of what’s called a “teaser period,” or how long your interest rate stays fixed at the beginning of the loan. (Think of teaser periods with credit cards, in which you avoid raises in rates for a specific period.) The teaser period for a mortgage is typically five, seven, or 10 years. 

Some ARMs include payment caps, which limit your monthly payment increase at the time of each adjustment, generally to a percentage of the prior payment. For instance, with a 6.5% payment cap, a payment of $100 could increase to no more than $106.5 in the first adjustment period, and $113 in the second.

When you look at loan repayment terms on ARMS, a 5/1 ARM would mean the initial rate would stay fixed for the first five years and change once a year after that. If the mortgage had caps of 2/2/5, that would mean the payment could go up 2% on the first adjustment and 2% on each subsequent adjustment, but not over 5% over the life of the loan. It is common for ARMs to have terms of 30 years.

Though many amortized loans are expressed in tables for reference, you can use an amortization calculator to see how much money you would pay in principal and interest over time. For instance, if you were to calculate a fixed-rate mortgage on a $225,000 home with a mortgage term of 30 years at 2.7% interest per year, you would pay $912.59 in monthly payments and total interest of $103,534.07 over the life of the loan.

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