Amortization

What Is Amortization?

Amortization is the gradual process of an outstanding loan balance dropping over time as the borrower makes monthly payments. On day one of the loan, the initial day the loan is funded, the entire balance of the loan is outstanding, i.e. still due. 

For a loan such as a home mortgage or a car loan, making monthly payments—which include both payments to principal and payments to interest—causes the outstanding loan balance to drop. This reduction in the outstanding loan balance is amortization.

It is a standard accounting practice to record amortization on balance sheets and income statements for corporations, and the practice is also undertaken by diligent individual property owners and investors. But amortization is more than just an accounting mechanism; it is how your lender records how much you still owe on a home or an investment property. Amortization is also part of the formula for how much equity someone owns in their home, and how the amount of equity someone has in a property grows over time.

Amortization has a broader definition across different types of loans and assets; however, the core philosophy is consistent across them all. When a loan is taken out by a borrower, the full outstanding loan balance is what’s owed. As the borrower makes payments, a portion of the payment goes to interest, and a portion of the payment goes to principal.

The amortization schedule for an individual loan/mortgage will be specific to that loan, but will be common across a class of loans like fixed-rate mortgages. On a standard fixed mortgage, a percentage of each monthly mortgage payment goes towards reducing the principal, and this reduction in principal is the amount the loan “amortizes” in that month. The portion of a mortgage payment that goes toward interest is not included in the amortization—this money for interest payment goes straight to the lender and does not affect the homeowner’s equity.

Implications for Home Owners and Investors

As a real estate investor or a first-time homeowner, you’ll want to set up an amortization schedule for yourself if you are not provided one from your mortgage lender in monthly statements. It is good policy to always be aware of how the reductions to principal on your mortgage start small when the mortgage is first taken out, but as time goes on, a greater portion of your (fixed) monthly payment goes toward reductions in the principal loan balance. 

This happens because as amortization reduces the principal still owed, the interest charged on that principal remaining also goes down, as intuition suggests. If a mortgage has a 5% interest rate on a $300,000 loan, and half the principal is paid off after a few years, that 5% interest is now being charged on just $150,000, not $300,000. So more of each monthly payment (which stays constant through the life of the mortgage) goes toward drawing down the principal in the later years of its lifespan.

Visually, amortization is typically displayed as a schedule—a table with line items indicating how the loan “loses value” over time (from the perspective of the lender) via reductions to the principal owed. The amortization table also shows how much cumulative money has gone to interest and to principal from every payment ever made on the loan.

Let’s walk through a quick example of how an amortization table looks and what it tells us about the nature of drawing down a loan over time:

Below we show the amortization table for a $150,000 15-year fixed-rate mortgage. The interest rate on the mortgage is 5% annually, or 0.417% per month. Monthly payments of equal amount are made by the mortgage holder of $1,186.19 per month. Over 15 years, the borrower will make 180 total payments, the last of which will reduce the principal owed to zero and close out the loan.

Draw your attention to the last two columns, for “Payments to Principal” and “Payments to Interest.” As you can see, each year more money is going toward drawing down the principal owed, and each year, more amortization occurs on the mortgage. In Year 1 of the mortgage, $6,890.78 is being amortized on the loan. In Year 2 more is amortized ($7,243.32) and so on through the life of the mortgage. 

Do All Loans Amortize to Zero?

Not all, but most mortgage loans (and all fixed-rate mortgages) will amortize to $0, reflecting the fact that when the last monthly payment is made, there is no more money owed on the loan; the property is paid off. 

A catch-all term for all loans that amortize this way is “installment loans,” as the borrower pays the debt down in equal monthly installments.

But some mortgages do not amortize to zero; in a balloon mortgage, there is a fixed amount of the outstanding loan balance due as the last payment in order to close out the mortgage. This balloon payment may be as much as 10-30% of the original principal.

There is also the case of the interest-only loan, which may end up amortizing to zero but does not amortize at all in the beginning of the repayment cycle. As the name suggests, early payments go entirely to interest with no portion of the monthly payment going to the reduction of principal.