Amortization

To amortize a loan is to extinguish it by means of a sinking fund; in other words, an allowance of payments over a period of time will be made to reduce the debt to zero.

The most common method of amortizing a mortgage is to have the repayment schedule computerized to ensure that all monthly payments are identical, with each payment containing the amortized principal amount, plus interest on the outstanding balance of the loan.

The following table shows the first 6 months repayment schedule for a 20-year, $20,000 loan at 10%, compounded semi-annually, each line representing one month's payment, and each payment being exactly $190.34.

In the beginning, each payment is practically all interest. As the loan progresses, each payment contains less interest, and more principal. Each monthly payment still remains the same, with a minor adjustment on the last payment (to take care of the fractions).

Note the allowances for principal payments during the final 6 months of this loan.

One thing to be quite clear about is that regardless of the differences of principal and interest in each payment, the borrower only pays interest on the outstanding principal balance of the loan at the time of each payment. As the loan progresses the borrower is making larger principal payments, because there is less principal on which to pay interest.

If this loan were amortized with equal principal payments, plus interest, this is how the monthly payments would vary:

The obvious disadvantage with this method is that the highest payments are in the beginning, when the homeowner probably needs all the available money to support his family.

With rising interest rates, the only possible way to keep monthly mortgage payments down is to lengthen the amortization of the loan. The following illustrates the repayment of 15-, 20-, and 25-year amortized mortgages of $50,000, 12% interest compounded twice-yearly.

The table presumes that the mortgage structures will remain constant throughout the loan, which they probably won't, but are used to illustrate the total amount of interest debt possible.

By adding $74.86 to the monthly payment on the 25-year amortization, bringing it down to 15 years, a total of$48,439.20can be saved.
And by reducing the 25-year deal to 20 years by adding $24.54 to each monthly payment, a very respectable $25,067.40 can be saved.
Further savings can be made by weekly mortgage payments, which are now available from several big lenders.

Do not confuse the amortization of a loan with its term. If one is told that a mortgage is amortized for 25 years, it must not be assumed that the loan has a 25-year term.

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