Mortgages: How Amortization Works And Why It Matters
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Looking to buy a house? Learn how to keep your mortgage affordable by understanding how amortization works!
What is Amortization for Mortgages?
Are you two looking at buying a house in the near future? Chances are pretty high you'd like to keep your mortgage affordable.
One of the best ways to prepare is understand the ins and outs of the process. An essential calculation is your amortization schedule.
Amortization is a method that lenders use to allocate payments of the life of the mortgage 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 goes towards paying interest. As the mortgages draw to a close, the payments increasingly towards the principal owed.
As an 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 amortization schedule is:
Source: Wikipedia
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.
Getting a Mortgage You Can Afford
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 the 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.
Your Take on Affordable Mortgage
How about you? Did you build a good size down payment? Are you accelerating your mortgage payments?
Yeah, the downpayment thing. I didn’t have a large down payment. I had 5% and the banks were very happy to give me 2, not 1 but 2 mortgages. Needless to say that hasn’t worked out so well for me.
I think you guys are taking the right approach while looking. 25% is a good number.
We’ve been using the Vertex spreadsheet for the past year, it’s great! We routinely apply extra to our mortgage but occasionally we get the chance to throw a chunk at it from a bonus or tax refund. Last year a single $12,000 payment knocked nearly $100K off our total interest paid through the life of the loan!
@Jeff: We’ll see how this goes, our first mortgage payment is in March. We’re also hoping to put a chunk of our tax refund to paying the mortgage down.
@LLC: Wow, that’s amazing how much you knocked down on interest with that lump sum payment!
We built our house from blueprints (with a builder, not like I picked up a hammer) and, knowing how things run over, we were preapproved for a 20% down mortgage, and had 10% more to cover the overruns which we paid as we went along. So while the bank saw 20% down, it was really 30. We started with a 30 year mortgage, but as rates dropped, we are on our 3rd refinance (all no cost, nada) and in the end will have paid the house in full in under 20 years.
I ran into a mortgage acceleration product, which I believed to be less than honest. As a result, I wrote a spreadsheet which can help readers see the impact of extra principal payments, especially how extra money in the early years knocks off payment 25-30 years later. I linked from my name, no signups, just a downloaded spreadsheet.
Thanks for sharing your personal story and the handy spreadsheet! I’m curious, how long did it take to build the house from the ground up? Do you have any tips on refinancing?
Elle – How’s the new house coming along? You guys pumped? this is helpful info for those with mortgages that pre-paying the principal with any disposable income is a good idea.
They poured the foundation just before it got cold, mid October. And we closed six months later. It’s on the big side of average.
I was fortunate to have a local bank that kept their loans in house, the refis were all with that bank which really made things simple. One thing people should consider, for example, if you have 18 years to go on your mortgage, refinancing to a lower rate 15 may cost you little more if anything depending on the rate drop.
For refinancing that has fees, there are the usual things to consider, primarily if you plan to be in the house long enough to recoup that cost.
By the way, see your amortization schedule? How in the first months, $148 goes to principal? If in that first payment, you simple add $148, you’ve just moved ahead a full month, permanently. You can always see how exactly how much principal it would take to get you ahead the next full month, and if it’s too much, pay half in each of two months. That amort schedule is the only tool people need to do this.
God luck on the house. Ethernet to every phone plate, and two cables to every plate for cable, to future proof yourself.
Elle,
I really enjoyed this post and thought you did a great job “breaking it down” into an easy-to-understand discussion. This is my first visit to your site, and it looks awesome!
Dustin
@FS: The snowstorm delayed our painting party, but we’re moving some of the smaller stuff in.
@Joe: I appreciate you sharing your take on it. I’ve had some friends refinance and they got a great deal, going down on their interest rates. Our plan is go ahead and put at least $150/month for the first year and hopefully build from there.
@Dustin: Thanks for visiting!