What is Amortization?
As you acquire a mortgage or other types of loan, you might receive an amortization schedule that outlines your loan repayments.
Many consumers don’t realize that even though their monthly payments stay the same throughout their loan, how much they’re actually paying towards their principal loan amount will change month by month.
Otherwise known as amortization, this financial system is the foundation of mortgage payments and is crucial to understanding when working in the real estate industry.
What Does Amortization Mean?
There are two primary meanings to amortization. In real estate, amortization is the gradual repayment of a loan. This includes a schedule of interest and principal payments of a loan until the entire amount is repaid with interest.
Originating from the old English language meaning “to kill”, amortization is a standard loan type often seen in mortgages. The slowly paying down of the loan amount “kills” the loan by the end of the term, usually around 30 years.
The other meaning of amortization is the spreading out of capital expenses relating to intangible assets over a duration. This is useful for accounting and tax purposes and is similar to the depreciation rate.
How Does Amortization Work?
Amortization is the process of spreading out the cost of a loan over a specified term amount, with fixed payments each month. A portion of each payment will go towards the interest charges, with the amount of interest paid each month decreasing over time.
A lot of financial loans are amortized, like credit card payments. But things like personal loans, auto loans, and mortgages are usually amortized and allow you to pay down the balance over time. There are pros and cons to an amortized loan, with the biggest benefit being a fixed monthly payment.
This often allows for a more reasonable repayment schedule with full transparency into how much each payment will be. However, a drawback of amortized loans is that the borrower doesn’t accumulate equity in the property on the front end. The longer the loan term goes on, the more principal paid and the more equity earned.
For a 30-year mortgage, this can mean that very little equity is established in the loan's first several years.
How is Amortization Calculated?
Borrowers and lenders use specific formulas and calculators to determine the amortization schedule for a mortgage.
As long as you know the interest rate and the principal amount of the loan, you can calculate the amortization yourself using the formula: Total Monthly Payment – [Outstanding Loan Balance x (Interest Rate / 12 Months)] = Principal Payment.
There are also countless online tools and resources if you’re not interested in calculating this rate manually. Additionally, you should receive an amortization table at your closing which outlines all the upcoming payments over the loan length and how much is designated to the interest versus the principal.
How Does Amortization Work in Mortgages
When you receive a mortgage, your monthly payment goes towards the principal amount and the interest charged to the loan, otherwise known as your PI payment. When you obtain an amortized loan, the monthly amount doesn’t change over the length of your loan.
However, the amount paid toward principal or interest differs over the length of the loan. When you reach the closing table, your lender will provide you with an amortization schedule or table. This will provide full transparency into each monthly payment you make over your loan.
In the first half of your mortgage, most of your monthly payments will go towards paying down the interest on the loan. However, as you reach year 15 or so, you will begin to pay more towards your principal than your interest. By the end of the loan, the majority of payments will be principal, and you will have “killed” the loan.
When you reach the closing table, your lender will provide you with a payment schedule that fully explains how much of your payments will be allocated to both principal and interest. If you opt for a shorter loan term, like a 15-year mortgage, the less interest you’ll pay. You’ll see that your monthly payments will pay more towards principal payments than a longer, 30-year mortgage.
If you’re interested in shortening your loan amount, making additional payments at the beginning of your loan is recommended to pay down your principal amount more quicker. This will help you save money on interest payments and allow you to “kill” the loan quicker. Make sure though there are no penalties for repaying your loan earlier.
Does a Rental Property Depreciate?
When amortization is applied to an asset like rental property, it is similar to the asset's depreciation. Rental property, unlike most other types of property, does depreciate. This is because there are costs associated with using the property as a rental like maintaining its condition and ensuring it’s a safe rental.
By spreading out these expenses throughout the loan, real estate investors can take tax deductions for their rental property. The Internal Revenue Service will allow taxpayers to deduct things like advertising, maintenance, property taxes, and utilities. Make sure you speak with a tax professional to fully understand the pros and cons of rental property depreciation.
However, if you’re currently a renter paying a similar amount as a mortgage payment, you should consider purchasing a home. Here’s why: every monthly payment you make as a renter is helping to build someone else’s equity in their property.
As a renter, you’re building no equity in your own home, and If you own your property, you’d be gaining wealth through property appreciation.
Final Thoughts on Amortization in Real Estate
Amortization schedules can be a new concept for buyers to understand as they go through the mortgage process.
As their agent, ensure they know how this amortization schedule could affect the equity they have in their home and how the repayment of their loan will work. Knowledge is power when it comes to real estate, and amortization is something all real estate agents should be prepared to walk their clients through.
TL;DR: Amortization is the process of paying down a loan over time. The term comes from the old latin word that means, "to kill." So, by repaying the loan, the debtor is "killing" the loan over time.