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What is Amortization for Mortgages?
Amortization is a method that lenders use to allocate payments of the life of the mortage that takes into account the principle and the interest. For a fixed rate mortgage the payment amount remains constant over the life of the loan.
For mortgages, in the beginning of your loan most of the money go towards paying interest. As the mortgages draw to a close, the payments increasingly towards the principle owed.
As example, I’ll use our own amortization schedule to show you the big difference. As you can see in the first screenshot, only about $150 of each month’s payments is going towards paying off our mortgage principle.
That’s why if you’re able to accelerate your mortgage payments with extra money going towards principle, you can cut years off your mortgage and save thousands of dollars by avoiding extra interest.
In the final year, you can see how the majority of the money is going towards paying down the principle.
Amortization Formula and Schedule for Mortgages
The actual formula used for calculating an amoritization schedule is:
Let me define the variables:
- P = Mortgage Principle
- A= Monthly Payments
- i = Annual interest rate divided by 12
- n=Total number of payments (for a 30 year loan, it’s 360)
If you’re looking for a free financial spreadsheet to help you with creating an amortization schedule, Vertex has a helpful one.
Obtaining Mortgages and Planning Down Payments
Running the numbers is important when buying a house and having an amortization schedule can help you get a house within your budget. As a part of financing, many lenders require that the home buyer obtain homeowner’s insurance. If the buyer has a down payment is less than 20%, they may also require private mortgage insurance (PMI). That’s one reason why you shouldn’t look at the minimum down payment you can get away with. You should examine and see how much you can put down on a house (and still have savings for an emergency).
Personally, we decided to go with a more conservative mortgage amount when we went looking at homes. Our goal was to keep our housing costs (mortgage, taxes, and insurance) no higher than 25% of our monthly income to give us a buffer. A lower mortgage meant a down payment was better for our budget. We wanted to make sure our cash flow remained positive on a month to month basis.
How about you? Did you build a good size down payment? Are you accelerating your mortgage payments?
Photo Credit: Fabio Bruna
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