Anyone who has purchased a home has probably heard the term “amortization”. However, that does not necessarily mean every homeowner understands it. Amortization is an easy concept for bankers and mortgage lenders to grasp because they have been trained in all the fine details of borrowing and lending. It is not so easy for the average consumer.
In the simplest terms possible, amortization is the process of combining both the interest and principal payments on a loan, then dividing it by the total number of payments to be made in order to establish a payment schedule consisting of consistent monthly amounts. Free online amortization calculators make it easy for consumers to figure out monthly payments by entering some basic information. However, the calculation can be made manually as well.
Amortization is based on two factors: principal and the annual percentage rate (APR) of interest. If you know your monthly payment, you can easily figure out how much is going toward principal through a simple mathematical calculation. Take your annual percentage rate and divide it by 12 (to account for 12 months of the year); multiply that number by the total balance still outstanding on the mortgage. The resulting number is the amount of interest for that payment. Subtracting the interest from the total payment tells you how much principal is being paid.
Working with these numbers assumes you are not paying extra every month for insurance or taxes in escrow. Those additional items are added to your interest and principal to determine your total monthly mortgage payment. As a side note, every payment you make reduces the amount of interest owed while proportionally increasing the amount of principal paid.
Amortization is a tool that makes it quick and easy to determine whether a borrower can afford to take a loan or not. It also helps the borrower more easily understand how much interest will be paid over the life of the loan — even if one does not fully understand how to make the calculations.
