You will hear this word all the time when you’re researching, applying for, and closing on your loan. Your loan officer can probably explain it to you, but amortization is something you should understand long before you apply for a specific loan, because the method and time-frame of amortization is what makes loans different from one another. We’ll explain what amortization is, why it’s used, and the variations you’ll see between different loan options. You might be surprised which loan is the cheapest from an amortization standpoint.
Investopedia defines Amortization as: “The paying off of debt with a fixed repayment schedule in regular installments over a period of time. Consumers are most likely to encounter amortization with a mortgage or car loan.” So, amortization is the schedule that is used to pay back your home loan. Amortization is how the lender calculates how much you need to pay each month to pay off the loan within the loan term (usually 15-30 years). With x percent of interest and y number of months, your lender calculates how much interest you need to pay each month and how much principal you need to be pay off each month to be finished by the end of your loan term and maintain the same monthly payment for the duration of the loan. At least, this is how a fixed-rate loan goes. We’ll talk about adjustable rates a little down the way.
Why Amortization is Used
Amortization is essential; it’s how the lender figures out how much the borrower is going to pay in interest and principal throughout the entire duration of the loan. There are such things as non-amortizing loans (referred to as balloon mortgages) but they really aren’t an awesome option. In a non-amortized loan, all you pay is interest (no principal) until the maturity date, at which point the entire sum of the principal (so like hundreds of thousands of dollars) is due at once. In a non-amortized loan, the entire balance is usually due within five to seven years. Since most borrowers are not interested in a balloon mortgage, you’ll find amortizing loans much more common.
Amortization Variations and Options
So, you can actually choose how you want your loan to amortize. You do this by what type of loan you choose. If you choose a fixed-rate mortgage, your loan will be amortized once at loan closing to calculate the minimum monthly payment you must make in order to have the loan paid off by the end of the loan term (usually either 15 or 30 years). If you choose a VA hybrid-ARM, your loan will be amortized once at the beginning of the initial fixed period, then amortized every year when the interest rate adjusts. This may sound like a bad thing, but it’s actually a very cool, underappreciated feature of the hybrid ARM. Allow me to elaborate.
If you are on a 30-year fixed and are making extra payments, your required minimum will never go down (unless you refinance). You’ll simply pay off your loan early, which is still a great thing. However, if you are on a hybrid ARM, your monthly payment will slowly go down over time if you make more than the minimum payment. Consider the following example: If you buy a home for $200k at 4.5% interest for a 30-year fixed, your minimum PI payment will be $1,013.37 for the entire life of the loan. If you buy that same home at that same rate on a hybrid ARM, after making the minimum payments + $100 each month for the first three years, your balance is at $186,436 (just like the fixed-rate would be if you paid $100 extra), but your loan reamortizes that year, and let’s say your interest rate stays exactly the same. For a $186,436 loan at 4.5% on a 27-year term, the minimum payment is $995.05, which is what your monthly payment would drop to in that scenario. Considering that starting rates on the hybrid ARM are actually much lower than fixed-rate mortgages, the difference is even more noticeable.
So that’s amortization, I hope that all made sense, and you have a better understanding of what your loan officer is talking about when they mention amortization.