Amortization: Defined and Explained


With the advent of so many creative lending programs for the consumer real estate market, it's important that Buyers understand the concept of loan amortization. Amortization of a loan is the systematic payment of both the principal and interest portions of the loan for a specified period of time until the borrowed amount is paid in full. You may have heard the terms, "fully amortized" or "partially amortized." Whether a loan is fully or partially amortized is important, because the installment payment amount will differ and may, in the latter case, require a balloon payment at the end of loan term to pay off any remaining balance.

Fully Amortized

A fully amortized payment schedule takes into consideration the amount of principal and interest a Borrower must pay over a specified period of time to fulfill the loan obligations. Each installment payment consists of a principal portion (deducted from the loan balance) and an interest portion (the loan underwriter's earnings).

When an installment payment is made, the debt balance is reduced, and the interest due on the next payment is recalculated based on the new (reduced) loan principal balance. However, your installment payment remains the same throughout the term of the loan. Each month the principal portion is increased and the interest portion is decreased (reduced). The loan obligations will be paid in full at the end of the contracted period of time.

Partially Amortized

Although partially amortized loan payments are still required on a regular basis and include both the principal and interest portions, these installment payments are not enough to repay the initial loan principal by the end of the term. Consequently, a balloon payment will be required at the end of the loan term.

Interest Only

Another type of loan is the "interest only" loan. The Borrower pays only the interest over the life of the loan, and the principal (initial loan amount) is due and payable at the end of loan term.

"Partially amortized loans" and "interest only" loans are becoming more common forms of funding. These types of loans enable Borrowers to qualify for a higher loan amount which increases their "purchasing power." It also provides an opportunity for Borrowers who are planning to keep a home for a short period of time (5 years or less) to purchase the home with lower monthly payments. In robust areas of the real estate market, Borrowers may receive an additional benefit: the accelerated appreciation of their home increases the rate of return on their initial equity investment (down payment) at minimal costs to the Borrower (lower monthly payments).

Amortization Table

In the Northwest Eddy Library, under the Basic Tools section, you will find an Amortization Table. This table will assist you in estimating your mortgage costs, principal, and interest payments, for loans with different time periods at various interest rates.

For example, choosing a home with a list price of $600,000 and deciding to make a $120,000 down payment will leave you with a remaining balance of $480,000 to finance. The property taxes for a given year are $6,000 and annual insurance premium is $1,200. The interest rate is currently 6.0%. To determine the payments for a 30-year fully amortized loan:

1. Divide 480,000 (loan principal) by 1,000 to arrive at 480.
2. Look at the Amortization Table's grid under Row "6.0%" (interest) and Column "30 year" (loan term).
3. Multiplying 480 by 6 (number which appears in the intersection in Step 2) equals 2,880 (PI).

The monthly principal and interest (PI) payment will be $3,480. To obtain a better estimate (called the monthly housing expense), continue with the following calculations:

1. Divide 6,000 (property taxes) by 12 (months) to get 500.
2. Dividing 1,200 (insurance premium) by 12 equals 100.
3. 2,880 (PI) plus 500 (property taxes) plus 100 (insurance premium) equals $3,480 (PITI).

The estimated monthly housing expense will be $3,480 (PITI). It is important that you confirm these estimates with your Lender. Keep in mind that to qualify for a mortgage loan, Fannie Mae and Freddie Mac underwriting guidelines suggest a monthly housing expense that is no more than 36% of your monthly income. The quick calculation above can take some of the mystery out of financing any purchase.

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