07.22.2024 PropStream
If you’re looking to purchase real estate or advise buyers as an agent, you’ve likely encountered the term amortization while researching loans. The word may sound complex, but it’s simply a method of paying off a loan in installments.
In this article, we’ll discuss what amortization is, explore how it works across various types of real estate loans, and answer some common questions about it.
Table of Contents
Key takeaways:
- Amortization is the process of paying off a loan in a set number of equal payments consisting of interest and principal.
- To calculate amortization for a loan, you need to know the interest rate, outstanding balance, and number of total payments of the life of the loan.
- Amortization can vary depending on the loan type, such as a fixed-rate mortgage, adjustable-rate mortgage, balloon loan, or other loan.
What Is Amortization?
Amortization is a common repayment process for car loans, student debt, personal loans, and real estate loans.
An amortized loan is paid off over a set number of payments consisting of interest and principal. In most cases, though not always, these payments are equal in amount.
Here’s how it works: The first portion of the monthly payment goes toward the accrued interest on the remaining loan balance. The remainder then goes toward paying off the principal.
As you continue to make payments, the remaining balance slowly decreases. This means the amount of interest within the total monthly payment decreases, too, allowing more of each payment to go toward the principal. This continues until the final payment and the loan is fully repaid.
Key terms to know:
- A fully amortized loan is one where, if you make all the monthly payments on time, you will pay off the loan at the end of the term.
- Positive amortization is a process of paying off the loan in a way that decreases the principal over time. When we discuss amortization in this article, we’re referring to positive amortization.
- With negative amortization, your minimum payments are not high enough to pay off the interest you owe. That interest is added to your remaining balance, causing your loan and, eventually, your payments to increase.
How to Calculate Amortization
To calculate amortization for a mortgage, start by multiplying the loan balance by the interest rate and dividing by 12. This gives you the amount of interest for the first monthly payment. If you subtract that interest from the total monthly payment, you get the amount applied toward the principal.
The principal payment for that month is then subtracted from the loan balance. The resulting balance is again multiplied by the interest rate and divided by 12 to get the interest required for the next monthly payment.
This continues until the principal is paid off completely. Most real estate mortgages are amortized over 15 or 30 years (or approximately 180 or 360 monthly payments).
Calculating a complete amortization schedule for a loan is a bit more complicated. To do so, you must figure out the total monthly payment, which requires a more complex formula. You can find free amortization calculators online to make the process easier and faster.
Example of a Mortgage Amortization Schedule
Here’s an example of an amortization schedule for a 30-year mortgage of $400,000 with a 6% fixed interest rate.
Note: The total monthly payments in this chart do not include escrow (property taxes and home insurance).
How Amortization Works With Different Types of Real Estate Loans
Amortization in real estate can vary depending on the type of loan you have.
Let’s examine a few of the most common types of amortized real estate loans:
Fixed-Rate Mortgage
In fixed-rate mortgages, the interest rate doesn’t change. This means the monthly payments stay the same unless property taxes and home insurance change. Many borrowers prefer fixed-rate mortgages because payments are more predictable.
The chart above illustrates amortizing a fixed-rate mortgage. Over time, the interest portion of the total monthly payment decreases while the principal portion increases.
Adjustable-Rate Mortgage (ARM)
During the introductory period, the interest rate of an ARM doesn’t change and is often lower than that of a fixed-rate mortgage. However, after that period, the rate can fluctuate. As a result, the interest portion of the total monthly payment can increase or decrease over the life of a loan, making payments less predictable.
Balloon Loan
Balloon mortgages are short-term loans that don’t fully amortize over the loan term. This is because monthly payments are calculated as if the loan had a 30-year term. However, at the end of the loan term—usually five to seven years—the borrower must pay a lump sum payment (also called a “balloon payment”).
Balloon loan payments can consist solely of interest in the beginning, or they can consist of interest and principal from the outset.
Home Equity Loan
Most home equity loans are amortized similarly to fixed-rate mortgages. The main difference is that you’re borrowing against the equity you’ve built up in the home. Terms can also vary from five to 30 years.
Home Equity Line of Credit (HELOC)
A home equity line of credit (HELOC) works somewhat like a credit card. During the draw period, you can borrow up to a certain amount. Once the repayment period begins, you must make periodic payments that include interest.
The amortization schedule for HELOCs is calculated like regular mortgages over the repayment period. HELOC interest rates are usually variable, so monthly payments can change over time.
The loan you choose when purchasing a property can impact your investment’s profitability. Knowing what amortization is and how it works can help you analyze loan types and terms to determine what works best for you and your real estate business.
Real Estate Loan Amortization Frequently Asked Questions (FAQs)
What happens if I make extra payments on my mortgage?
Making extra mortgage payments will bring down your loan balance faster. This decreases the amount of interest you’ll pay each month and shortens the life of your loan. However, be sure to check with your lender to make sure there are no penalty fees for paying off your loan early.
Can I change my mortgage’s amortization schedule?
Yes, you can change your loan’s amortization schedule by refinancing with a shorter or longer term. You can also see if your lender is willing to modify the loan term or interest rate. Making extra payments can also help you pay off your loan early and, in effect, shorten your amortization schedule.
What’s the difference between depreciation and amortization?
The term “amortization” can be used in two ways. The first, as described in this article, refers to a systematic process of paying off a loan. The second is an accounting term describing a systematic way of deducting an asset’s cost from your taxes over a period of time.
The second definition is similar to depreciation. However, while amortization is often used for intangible assets (like trademarks or copyrights), depreciation is typically used for physical assets that deteriorate over time, such as homes, machinery, or equipment. Also, there are many ways to calculate depreciation, but the straight-line method is generally the only method used for amortization.
