Mortgage amortization is a financial term that refers to your home loan pay off process. When you take out a mortgage, the lender creates a payment schedule for you. This schedule is straightforward and, if you have a fixed-rate mortgage, consists of equal installments throughout the life of your loan. What you may not know is that part of this monthly payment covers interest while another part goes toward your loan principal. Although the monthly payment amounts remain fixed, it's important to realize that the allocation of those dollars is gradually adjusted as you pay off your mortgage.
Here's everything you need to know about principal and interest payments and how they can affect your loan pay off. Understanding your home loan amortization schedule can help you make informed decisions regarding your mortgage.
How home mortgage amortization works
When you make your monthly mortgage payment, the lender divides the total amount into two buckets:
- Principal: This is the outstanding balance on your loan.
- Interest: This is the cost of financing your home.
Some mortgage payments may include an amount for escrow, which is used to pay items such as your property tax and homeowners insurance. However, some loans may allow you to pay those amounts on your own and limit your mortgage payment to Principal and Interest (P&I) only. The following refers to your P&I payment.
At the beginning of your loan pay-off period, the bulk of your payment is applied to the interest bucket with a small portion going toward the principal. As the lender covers the cost of financing your home purchase, the payment allocation begins to change. Over time, a larger percentage of your payment goes toward the principal and less to interest.
If you keep close track of your loan balance, you’ll notice the amount you owe diminishes slowly at the beginning of your loan. You’ll also notice that it drops much faster toward the end of the pay-off period since interest is calculated on the loan balance. The loan balance reduces every month as you pay off your mortgage. Therefore, so does the interest.
During the first years of your mortgage, you’re paying off more interest so it’s normal for the balance owed to decrease gradually while your home equity increases slowly. But during the final years of the home loan, the opposite will happen. At the beginning of your loan, you pay more interest. Then, as your loan ages, more of your payment goes toward the principal. Your balance owed will decrease quickly as you build home equity exponentially since you’re now paying off more of the principal.
Sample home mortgage amortization schedule
The complete breakdown of your payments is available in an amortization schedule, also known as an amortization table. This is where you can see how much of your payment applies to principal and interest. It also provides information on the remaining mortgage balance as well as your loan’s fixed end date.
Below is a sample amortization table for the first few monthly payments of a $500,000 home loan at a 3.1% interest rate, as well as another few months much later in the loan: