What Does Mortgage Amortization Mean and Why Do Loans Have It?

When you borrow money these days to finance the purchase of a home, you generally take out a loan that is called an amortizing loan and it is for a 30-year term. Each payment you make is the same fixed amount for the entire term of the loan. And with this type of loan, each payment pays off a little bit of the principal balance (the money you actually borrowed) in addition to the interest you owe on the money you borrowed. By paying off a little principal of the loan off each month, at the end of 30 years, the loan is completely paid off and you should own the home free and clear. It’s a great system and works really well, but you may not know that it wasn’t always this way.

Back in the early days of mortgage lending in the U.S., individuals who were buying property might have been able to get a loan to help finance their purchase. My great grandfather bought a $15,000 townhome in Philadelphia in the 1920s and he paid $5,000 in cash for it and borrowed the other $10,000. At that time in our history, the bank would loan the $10,000, he would pay monthly interest on the loan, and at the end of the loan’s term of five to ten years, he would pay back the entire $10,000 outstanding balance.

Well, this system worked great — that is, until it was time for the outstanding balance to be repaid. If the borrower couldn’t refinance that loan with another bank, they usually would not have the cash needed to pay off the loan. Then the bank would have to renegotiate or foreclose on the property, and banks want to be paid on time, not own property or renegotiate loans.

As a result, some brilliant person came up with the idea to make loans that paid interest plus principal back to the bank, so that they would be paid off at the end of the loan term. That is called amortization. After I did my research, I can’t find any conclusive information on who exactly came up with this amortization idea, but what we do know is that the 1934 Federal Housing Administration Act  authorized its use by government-backed lenders. Since then, it has become the gold standard for just about every aspect of the mortgage market in the U.S.

But how is it calculated, you ask? An amortizing loan payment is calculated by a computer using the amount of the loan, the interest rate on the loan, and the amortization time period, like 30 years. For example, let’s say you borrowed $100,000 at 4.0% interest for 30 years (360 months). The calculator would come up with a monthly payment of $477.42, so you would make the same fixed monthly payment for the next 360 months and your loan would be paid off.

But that payment is comprised of both principal and interest. This means the first month’s payment would be $144.09 in principal and $333.33 in interest, for the total $477.42 payment. To understand the calculations, it’s easier to tackle the interest portion. It’s the $100,000 outstanding balance multiplied by 4.0% and divided by 12 months, which equals the $333.33. The principal portion is just the difference, so the $477.42 fixed payment less the interest of $333.33 equals the principal portion of the first mortgage payment of $144.09.

The second monthly payment would still be the fixed $477.42, but the portions of interest and principal change. It would be $332.85 in interest and $144.56 in principal. With each payment, the interest amount decreases and the principal amount increases, so you are paying off your loan faster.

The mortgage gets paid down each month for the term of the loan, which is typically 360 months or 30 years. The last loan payment will be made that 360th month. And since there won’t be much loan balance principal outstanding because you’ve continuously paid it down, and the interest is calculated off that outstanding balance, the $477.42 last fixed monthly payment will be comprised of $1.59 in interest and $475.68 in principal. And then you’re done and get to celebrate the fact that you now own your home free and clear!

Just about every mortgage loan today is an amortized loan and it is usually 30 years, which is the standard, or could be 15 years if a borrower can afford larger payments. Either way, if you make all your payments on schedule, your loan will be paid off, and it has got to be a pretty good feeling to make your last payment. I will be there in about 20 years.