How Amortization Works

Amortization is a term that is commonly used in describing financial loans.

There are other things regarding repayments like insurance that uses amortization. But it is most often used when describing mortgages.

Amortization refers to scheduled repayments where the amount in excess of interest due is used to repay the loan principal.

For example if a monthly $900 repayment makes up of $200 in interest payment, the remaining $700 is paid to reduce the principal owing balance.

This process is amortization.

Most term loans offered by banks uses an amortization table to show the breakdown of the repayment schedule. It would show the portion that goes towards repayment of interest and the portion that goes towards repayment of principal.

With this information, a borrower would be able to tell how much principal is left on the loan at any point in time. This can be important information when the borrower is considering a full redemption.

In the strange even whereby the scheduled payment amount is insufficient to settle the interest due, it results in the rise of the outstanding balance. Negative amortization has occurred.

Fully amortizing payment

The monthly installment payment that will fully repay the outstanding loan at the end of the scheduled term is the fully amortizing payment.

For a fixed rate mortgage (FRM), it is very straight forward.

As the interest remains flat and do not change over time, it is a simple process to calculate the monthly payments so that upon completion of the loan tenor, the full outstanding debt is repaid.

For example, for a $250,000 mortgage at fixed 5% over 25 years, the fully amortizing monthly payment will work out to $1,462. Making this payment amount each monthly will fully pay off the mortgage principal and interest over 25 years.

When it comes to an adjustable rate mortgage (ARM), the mechanics are a little more complex.

Because a key feature of ARMs is the changing interest rates before and after the adjustment interval, the fully amortizing payment changes as the interest rate changes.

For example, the monthly payment for a $250,000 loan at 5% over 25 years is $1,462. Should interest rates rise to 6% after an adjustment interval, the new fully amortizing payment will become $1,611.

Standard loan amortization

In practice, there are only 12 days in a year when accounting for mortgage amortization. The 12 days are made up of the first days of each month.

This means that the day before the first day of the month is the last day of the month before. The day the loan close.

Since borrowers pay per diem interest, the first monthly mortgage payment actually starts on the first day of the second month.

For example, if a loan closes on the May 10, the interest due at closing will be for the period of May 10 to June 1. And the due date of that first payment will be July 1.

The payment towards interest is calculated by dividing the interest rate by 12.

If for example the interest rate is 9%, dividing that by 12, or multiplying it with 1/12, will result in 0.75%. If the loan is for $100,000, then portion of monthly payment going toward interest is $750. The remaining balance of the payment will be paid towards the principal to reduce the balance.

Because mortgages are typically structured with a reducing interest rate, the allocated portion of the payments made towards interest expense gradually declines over time. Bigger portions will be paid towards the principal simultaneously.

As long as payments are made before going overdue, even if it’s within the grace period, they are treated as if the payments were made on the first day of the month.

However, should payments be missed, the borrower would absolutely incur late payment penalty charges until the payment is made. On top of that, you can expect the creditor to file a delinquency in the borrower’s credit report.

The lender will then expect 2 payments by the next due date.

If payments for tax and insurance are made by the lender, amortization schedules prepared by banker and brokers should show them together with the balance of both in the escrow account.

Simple interest amortization

The main difference between a simple interest mortgage and a standard one is that the former calculates interest on a daily basis rather than monthly.

The principal will be based on the balance on the specified day of payment.

For example, under a standard mortgage for $200,000 at 6%, the monthly payment would be calculated by $200,000 x 6%, divided by 12.

For a simple interest mortgage, the calculation becomes $200,000 x 6%, divided by 365. The monthly payment will the multiply the result with the number of days in the month.

Simple Vs Standard Mortgage

Should a borrower be a disciplined person or entity who makes prompt repayments in full on the first day of every month, there is basically no difference between simple interest and standard loans.

The number would work out the same at the end of the financial year.

However, when late payments are taken into consideration, the grace period (usually 15 days) that comes with standard mortgages means that borrowers will enjoy “interest free” days on that lateness.

But because simple interest takes into account days instead of months, a late repayment means that a borrower with such a loan will have interest accumulated over the number of days late.

With the same dynamics, when a borrower makes extra payments or partial redemptions towards the amount owing, they would be paying for more interest on a simple interest loan.

Yet simple interest loans don’t only come with drawbacks. It would be a good choice for borrowers who have a habit of paying early.

Paying early would result in credits in the loan repayment account as the interest has technically not been tabulated yet.

These extra payments would help the borrower save on interest charges over the number of days the payment is made early.

As a final thought, a house is quite possibly the single most expensive commitment that most people will make in a lifetime.

With that comes a mortgage which would become the single most expensive liability in a lifetime.

For the purpose of financial planning, it pays to understand amortization and the dynamics of how the loan works.