Purchasing a home is a significant milestone in many people's lives, and for most, it involves securing a residential mortgage. Understanding how your mortgage payments are structured is essential for successful financial planning. One crucial aspect of mortgage repayment is amortization. In this blog post, we will explore the concept of amortization as it relates to residential mortgages, including how monthly principal and interest payments are calculated, the impact of principal curtailment on the repayment schedule, and the benefits of making one extra payment per year.
What is Amortization?
Amortization refers to the process of gradually paying off a loan, such as a residential mortgage, over a specific period through regular installment payments. With each payment made, a portion goes toward reducing the principal amount owed, while another portion covers the interest charged by the lender. Over time, the principal balance decreases, resulting in a gradual reduction of both the interest paid and the length of the loan.
For all you math people out there, here is the actual amortization equation:
Monthly Principal and Interest Payments:
When you secure a residential mortgage, the lender will provide you with an amortization schedule that outlines the repayment plan for the life of the loan. This schedule includes the total loan amount, the interest rate, the loan term, and the monthly payment amount.
The monthly payment is typically divided into two components: principal and interest. The principal portion goes towards reducing the loan balance, while the interest portion compensates the lender for borrowing the money. Initially, a higher proportion of the payment goes towards interest, while less of the payment is applied toward the principal. It really isn’t until about year 20 (of a standard 30 year term) that more of the payment is applied toward the principal than interest.
Let’s consider the following example: a 30-year fixed-rate mortgage of $300,000 with an interest rate of 7%. Using a mortgage calculator, we find that the monthly payment amount would be approximately $1,996. At the time of the first due date, $246 of the payment goes toward the principal and $1,750 goes toward interest. Over time, more of the total monthly payment is applied to the principal and less toward the interest. See the chart on the left that shows the amount of interest paid v. principal paid each year. Notice how more and more goes toward the principal as the loan progresses through the schedule. I also included a monthly breakdown on the right to show you a more focused view of what transpires each month (view of the first two years).
Effect of Principal Curtailment:
Principal curtailment refers to making additional payments towards the principal balance of the mortgage, beyond the scheduled monthly payments. By making principal curtailments, homeowners can reduce the overall interest paid and shorten the loan term.
When extra payments are made toward the principal, they directly reduce the outstanding balance. This reduction has a compounding effect on subsequent interest calculations, resulting in a faster decrease in both the principal and the overall interest paid.
For instance, let's assume a homeowner decides to make an extra principal payment of $10,000 in the fifth year of a 30-year mortgage. By doing so, the remaining balance will be reduced, and subsequent interest payments will be calculated based on the lower balance. This will result in an accelerated repayment schedule, potentially shortening the loan term by several months or even years, depending on the amount and frequency of the additional payments.
Effect of Bi-weekly Payments on an Amortization Schedule:
You may see mention of the advantages of paying your mortgage bi-weekly as you do your research. The advantage is that you will ultimately be sending 1 extra full payment a year that will be applied directly to the principal, therefore reducing the total number of payments required to pay off the loan. Think of it this way, there are 52 weeks in a year, and 26 bi-weekly periods, where you would pay ½ of the total mortgage payment every two weeks. This equates to 13 full monthly payments or 1 more than the required 12 monthly payments. The actual math looks like this:
If you make regular monthly payments of $1,995.91 for 30 years on the mortgage terms mentioned above, you will pay the loan off in 30 years and the interest due over the entire term would be $418,526.69. If you paid bi-weekly, i.e., you paid $997.96 every two weeks, you would pay off the loan in 26.42 years and pay total interest of $359,065, which is $59,461.50 less in interest than paying the standard monthly payment.
Not all lenders allow for bi-weekly payments on mortgages, so keep that in mind.
Conclusion:
Most homeowners do not understand the concept of amortization and they really should. It is highly advisable to watch a quick video on YouTube about how amortization works to further solidify this, as it will allow you as a homeowner to take advantage of potential money-saving opportunities!