What is Mortgage Amortization?

Mortgage amortization is a situation in which the principal balance on a mortgage declines over time as the borrower makes periodic payments. As a general rule, amortization is a very desirable state of affairs, because if a mortgage is not amortizing, it means that the borrower is not making any headway on the loan. Historically, most mortgages were designed to amortize automatically as long as the borrower made the minimum payments, although slightly different arrangements including negative amortization mortgages and adjustable rate or interest only mortgages have also been used.

When a borrower takes out a mortgage, the bank sits down to determine the amounts of the periodic payments over the life of the loan. Each periodic payment must fully cover interest and include a proportion of the principal for the mortgage to amortize. The goal is for the mortgage to be fully amortized, a fancy way of saying “paid off,” at the end of the term of the loan.

In a situation where mortgage amortization is not occurring, the periodic payments will need to be adjusted so that the borrower is paying against the principal. This can be startling for borrowers, as their payments may jump suddenly.

Amortization accounting can get extremely complicated. What borrowers need to know about mortgage amortization is that it starts off slowly. In the early years of the loan, the bulk of the payments are applied to interest, with only a small percentage going against the principal. As more and more of the principal is paid down, the interest declines, leading to greater mortgage amortization in the later years of the loan and a subsequent increase in borrower equity in the house.

Many borrowers sit down with a mortgage calculator when they are getting ready to take out a loan, plugging in the amount of their down payment, the amount of the loan, and the interest rate to get an estimate of how high their monthly payments will be. One thing to consider when taking out a mortgage is the amount of money which will be paid out over the life of the loan; with a mortgage calculator which estimates monthly payments, it can be difficult to see the big picture. Payments on a mortgage with a high interest rate and a long term could easily double the amount of loan or more, which is generally undesirable.

Thanks to the complexities of amortization accounting, most banks are very rigid about payment amounts. Some banks actually fine borrowers who try to overpay each month with the goal of paying their mortgages down more quickly, while others will accept overpayments, but they take them off the end of the loan, rather than giving a borrower a break on the next payment. In other words, if a borrower makes a big payment in December, the bill for January will not be reduced. Instead, the bill for the final mortgage payment will be reduced, shortening the life of the loan. Borrowers who plan to pay over the minimum should find a lender which permits this practice.