How Amortization Works

Many people want to know more about their mortgages, and have questions about how they work. While many of the questions have an easy answer, some are more complex. No matter what you want to know about your mortgage, a good starting point is a thorough understanding of mortgage accounting and the workings of amortization.

For amortized mortgage accounting purposes, the year can be thought of as consisting of only twelve days – namely, the first day of each month of the year. Accounting begins on the first day of the month following the loan’s closing. Interim interest is charged for the period of time between closing and the next month.

Monthly interest payments are determined by first dividing the yearly interest rate by twelve. For example, if you have a $100,000 loan at six percent interest and a 30-year term, your divide six percent, or 0.06, by twelve, to arrive at .005.

The first month’s interest payment will be equal to the product of .005 and $100,000, or $500. For this loan, the total monthly payments are $599.56 each month. Therefore, in the first month, $500 of the payment would be applied to interest, and $99.56 would be applied to principal and reduce the loan’s balance.

This is the basis upon which amortization works. For the second month, the principal is reduced to $99,900.44. This number is then multiplied by 0.005, to get an interest payment of $499.51, with the $100.05 remainder of the monthly payment being applied to principal.

Each month, this process continues on in this manner, with the principal being reduced more and more with the passing of months and years. Through amortization, the balance of the loan will be cut in half after approximately 21 years. After 30 years, the term of the mortgage, the principal will be paid off completely, unless early payments have been made. In this case, the loan will be paid off before term, however, just how far before term will depend on the extent of the prepayments.