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How Does Amortization Work

How Does Mortgage Amortization Work?

Are you ready to own your very own Kansas dream home?

It’s never been a better time to buy a home. Interest rates are down and there are lots of options on the market.

But along with the home, comes the mortgage. And getting a mortgage is sometimes confusing. There are terms thrown around like adjustable rate, annual percentage rate, and amortization.

That’s where we’re here to help. We’ve got all the resources you need to buy your new home.

And that starts with understanding some mortgage basics. Here’s our mortgage guide: how does amortization work?

Some Definitions

Amortization, as it applies to a mortgage, is when you pay off debts in regular installments over time.

There are two parts to your monthly loan payment: interest and principal. Interest is what you pay the bank for the use of the money. Principal pays down the balance on your loan.

For example, let’s say you have a $100,000 home loan and you make a payment of $1,000. Of the payment, $300 goes to interest and $700 to principal. After you’ve made your payment, you’ll now owe $99,300 on your mortgage.

Types of Home Loans in Kansas

There are three main types of home loans. They are amortizing, revolving, and bridge.

A revolving loan is like a credit card in that the balance revolves up and down. This is called a line of credit. An example of a revolving home loan would be a Home Equity Line of Credit (HELOC).

A bridge loan is short-term in nature. These loans are set up with a lump sum principal payment due at a specific time and interest payments due in the interim.

An amortizing loan is the type of loan we’ll discuss here. These are, by far, the most common types of home mortgages on the market. With an amortizing loan, you pay a set monthly payment that lowers your mortgage balance over time.

Terms of an Amortizing Loan

Once you’re pre-approved for a home loan, your mortgage lender gives you options for amortization terms. And calculates your payment based on these terms.

The first term of the loan is the interest rate. Next is the length of the loan, usually in years. Finally, you choose a fixed or variable rate.

The interest rate often varies depending on the length of the loan. For example, your lender may offer you a $100,000 mortgage at 4.00% for 20 years. If you choose to finance longer, like 30 years, the rate may increase to 4.50%.

The rule of thumb: the less time you have the home financed, the lower your starting rate is. If you go with a long-term, fixed rate, then the rate stays the same throughout the entire term.

How Does Amortization Work?

Now your lender calculates your exact monthly payment. This is the schedule of loan payments.

Fully-Amortizing Loans

A fully-amortizing loan pays off in full at the end of the loan term. As opposed to a balloon loan, which we’ll discuss later in the article.

Let’s return to our $100,000 mortgage example. If you choose to repay your mortgage on a 30-year amortization at 4.50%, your mortgage payment is about $507. That’s 360 payments and your loan is done.

How did we figure that? We used an online mortgage calculator.

There are ways to set up your own amortization calculator in a spreadsheet. But we recommend using the online version. They are easy to use and accurate.

Plus, you can scroll down through the calculator and see how much of each payment goes to principal and how much goes to interest. At the beginning of the loan, most of the payment is interest, but this flips to principal at the end.

Another rule of thumb: the longer you finance, the lower your monthly payment.

In our example, if we changed it to a 20-year amortization at 4.00%, your payment is $606. Your monthly payment is $100 less, but you’ll have your home paid off 10 years earlier.

Choosing the best amortization length is a factor of your circumstances. It’s also important to remember that the longer you finance, the more interest you’ll pay.

If you need more monthly income, you should finance on a longer term. If you are okay with paying a higher monthly payment, finance on a shorter term.

Balloon Loans

Some lenders offer fixed rate loans called balloon loans. A balloon loan has an amortization that is independent of the time it takes to pay the loan.

Here’s another example to illustrate. Your mortgage is $100,000. Your lender sets it up on a 30- year amortization at 4.5% with a five-year balloon.

The mortgage payments for the first five years of the loan will be the same as we discussed in the original example. Monthly payment is $507 for 60 months.

After 60 months, the remaining principal balance is due. In most cases, the lender refinances this balance with similar terms.

Balloon loans are less common than fully-amortizing loans. But there are several situations where you might want one of these loans.

1. You’re planning to sell the home before the five years are up. Some banks offer better interest rates if you opt for a balloon loan.

2. You think rates will drop between now and the time your balloon is due.

3. You plan to pay off the mortgage with a lump sum at that time. This might be good if you know you’ll run into a sum of cash between then and now.

There are pros and cons to both types of loans. If you’ve got a high rate, then you might not want to finance long-term. Discuss these topics with your mortgage lender so you’re informed.

The Basics of Amortization

Buying a home is one of the most exciting things you will do in your life. Don’t let fancy terms confuse you. If you’re informed before you talk to the mortgage lender, it makes the process smoother.

So how does amortization work? Amortization is your loan payment schedule. Every loan that has regular payments has an amortization schedule.

If you’d like to learn more about mortgage options available to Kansas residents, visit our loan options page. And call us the next time you’re looking for a top-quality mortgage lender!

Rick Woodruff
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