What is amortization and how does it work?

What is amortization?
This is the lifetime of your loan. For example, most mortgages have an amortization of 30 years, meaning your mortgage will be paid off after 30 years.

Amortization is the repayment of debt with regular installments of principal and interest.

A fully amortized loan has regular equal payments that are large enough to pay all the interest up to date and pay some on the principal balance to reduce the amount owed to zero by the maturity date of the loan.

The majority of each payment at the beginning of an amortization loan pays for interest. As time goes on, more and more of each payment covers your principal. You are then “amortizing” the loan.

Some "Pay Option" loan programs allow what is called negative amortization. This is where the borrower is allowed to make a monthly payment that is less than the monthly interest charge. The difference is then added back on to the total loan balance. Obviously, a consumer could only accrue negative amortization for so long. Most lenders place a restriction of five years or 125% of the original balance before the loan recasts. When this happens, the loan returns to a regular payment schedule.

There are mortgages available where the amortization period is longer than the time required to pay the mortgage back. These loans are called balloon mortgages. A balloon mortgage is a mortgage that has an amortization period longer than the amount of time you have to pay the loan back. For example a standard 30/15 balloon mortgage will have an amortization of 30 years but the loan is due in full at the end of 15 years.

There are new amortization periods being introduced yearly. 40 and 50 year amortizations are available to help you qualify for larger loan amounts.

It can be confusing when looking at loan programs. When you have two numbers separated by a slash (/) you could be looking at either a balloon program or an ARM program. When the first number is smaller than the second, 2/28 or 5/25, this is an ARM program. When the first number is larger than the second, 30/15 or 40/30, this is a balloon program.

In a fully amortized loan, in the beginning of the loan term, a majority portion of the payments go towards paying for the interest and only a small part of the payments pay down the principle. Although all the payments are identical throughout the loan term, a bigger portion of the payments go towards paying off the principle in the end of the loan term.

» DISCLAIMER: The information contained in this article on 'What is amortization and how does it work?' is a collection of contributions by licensed mortgage professionals and is not the opinion of Broker Outpost LLC. Always consult a licensed professional before applying for a mortgage.