Why You Need To Understand How Mortgages Work

Mortgage amortization. A mortgage is easy enough to understand. That’s the loan you take out to purchase a house. But what about amortization? And how does mortgage amortization specifically impact you as a homeowner? Let’s break it down in a way that makes sense. Then you can manage your mortgage in a way to help maximize your money.

Let’s start at the start.

First-time homebuyer? Here’s a great article from Redfin with tips for first-time home buyers.

What Is a Mortgage?

A mortgage is a loan we take out from a bank to buy a house. As part of that agreement, the house itself is used to guarantee the loan. If you stop making payments on the loan, the bank can take the house and sell it to get their money back.

Popular mortgage arrangements include variable and fixed-rate options. The length (term) of the mortgage can also vary. Terms can be as short as 5 years or as long as 40 years. The two most common mortgage terms are 15-year and 30-year.

Mortgage terms are going to be an important point when we explain mortgage amortization in just a moment.

What Is Amortization?

Amortization is defined by investinganswers.com as:

“[A]n accounting term that refers to the process of allocating the cost of an intangible asset over a period of time. It also refers to the repayment of loan principal over time.”

I don’t know about you, but that isn’t much clearer to me than just using the original phrase.

Essentially, amortization is how the pay-back of a mortgage is structured.

When a mortgage is amortized, the amount of principal vs interest is determined. These aren’t just set once for the life of the loan. No. The amount of principal versus interest changes every single month. That’s the amortization process.

Your Mortgage Payment

Let’s pick some numbers to use in an example. I think that will make this more clear and easier to understand.

Say you are buying a house for $200,000. You’ve done a great job saving and are able to put 20% down – $40,000. After the down payment, you still need $160,000 to complete the purchase. That’s how much of a mortgage you’ll need.

You talk to multiple banks because that’s the smart thing to do. When the banks provide a quote back to you they’ll hopefully mention the two most popular terms – 15-year and 30-year. By the way, the interest rate on a 15-year loan is going to be lower. The reason is that the shorter payback period means less risk for the bank.

For this example, let’s assume a couple of interest rates. (You can go to BankRate.com to current check local rates.) Let’s say you find a 30-year mortgage at a 4% interest rate. Or a 15-year mortgage with a 3.365% interest rate.

The 30-year mortgage payment would be $763.86/month.

The 15-year mortgage payment would be $1,133.23/month.

Of course, your actual payment will be higher than that because the bank pays your taxes and insurance for you. But using these numbers will work perfectly in demonstrating how mortgage amortization works.

An interesting point to notice and understand. In this example the 15-year mortgage payment is less than 50% higher than the 30-year mortgage. You might assume that since you are paying it off twice as fast that the payment would be about double. It isn’t. This is one of several reasons most homebuyers should at least consider a shorter term loan. You’ll pay your mortgage off faster and save a ton of money. More than $100k would be saved in this example.

Mortgage Amortization (30-Years)

Here is how mortgage amortization works. Take a look at the chart below.

This amortization chart gives a visual example of how your mortgage payment is allocated by the bank.

Notice that even though the payment is the same every single month, the part that goes toward actually paying off the mortgage loan balance (the “principal”) changes.

Because of the way mortgage amortization works, the payments made near the beginning of the loan largely go to interest payments. That means in the first few years of living in a mortgaged home you pay only a small portion of the loan balance back.

Considering the example numbers above, here is what the home buyer would have paid at the end of five years.

Total Payments: $45,831
Interest Paid: $30,547
Principal Loan Paid: $15,283
Principal Loan Balance: $144,716

That’s right. In the first five years of a mortgage, you pay almost twice as much money toward interest as you do the mortgage principal balance.

Five years of paying into your mortgage – almost $46k of payments – and you have only built-up $15k worth of equity in the house.

Bummer isn’t it.

Understanding this can have a big impact on your wealth. Stick with me here for tips on using this knowledge to help maximize your money.

Mortgage Amortization (15-Years)

Let’s look at the 15-year mortgage amortization data now.

As mentioned above, a 15-year mortgage payment in this example would be a bit less than 50% higher than a 30-year payment.

Here is a similar chart as above but with two changes: a 15-year mortgage term and a 3.365% interest rate.

Part of every payment is still allocated to interest and part to paying down the principal balance. But the shorter loan term has a huge impact on the percentage allocated to each. Right from the start with the shorter mortgage you are paying more principal than interest. That’s a huge win!

Here is how you would stand at the end of five years paying on this example mortgage.

Total Payments: $67,994
Interest Paid: $23,330
Principal Loan Paid: $44,663
Principal Loan Balance: $115,337

Compared 15 & 30 Year Mortgage Amortization

Sure, with a 15-year loan you pay more each month. Over the five-year example period, you would pay $22,163 more. That’s a pretty big number, but it’s spread over five years, so it works out to just around $369/month.

What would you have gotten for that extra amount paid?

You would save over $7,000 worth of interest paid and you would have almost $30,000 more equity in the house.

Think about that.

You pay $22k more but your home equity increases by almost $30k. That seems like a good idea to me.

3 Takeaway Tips From This Mortgage Amortization Lesson

To help minimize the amount of money you pay your bank in interest, and increase your home equity, consider whether one or more of these three tips make sense for you.

1. Get a shorter mortgage loan term.

If you can afford the payment of a shorter term, why not do that? As you can see from the numbers above there are solid financial benefits to choosing this option. Of course, before taking on any mortgage you need to step back to understand your cash flow, consider your goals, and determine how the move will align with your financial plan. This is definitely an option worth considering.

2. Make extra principal payments.

Whether you currently have a 15-year, 30-year, or another term loan, you can always speed up the mortgage amortization.

You would do this by making extra payments specifically toward the principal loan balance. In fact, let’s say you have a 30-year loan. If you calculate what that same loan would cost on a 15-year term then pay the additional amount each month toward principal, you’re basically turning it into a 15-year loan. You’ll experience the same savings and faster equity build-up as-if you had originally taken a 15-year mortgage loan.

These extra payments can be made each month but they don’t have to be. If it works better for your cash flow you could make an extra payment once or twice per year. The key is to a) pay extra and b) pay it specifically toward the mortgage principal.

[Think it would be better to invest that money? Maybe. But be sure to consider the points I mention below on that topic.]

3. Stay in your house longer.

Regardless of the loan term, because of the way mortgage amortization works, you pay more interest at the beginning of the loan. The longer you stay in that house and pay on the loan, the higher percentage of each monthly payment goes to paying principal.

A family that moves every 5 years or so, buying a house each time, is very likely destroying their wealth rather than getting ahead. This is especially true once the average selling transaction fee of 6% is added into the mix.

Just staying in your house longer will automatically accelerate the principal payoff over time.

Thoughts On Early Mortgage Payoffs

I’m sure at least one reader is thinking: “Why not take that extra money and invest it to earn 8% instead of paying off the mortgage faster?”

Like most financial planning topics, whether it makes sense for you or not depends on a number of factors. Clarifying those factors and working them into an overall financial life plan is another reason working with a financial planner can be extremely valuable.

But consider these points…

Would You Really?

In reality, based on numerous studies, when people “save” money by lowering their payment amount they rarely invest the difference. More often that money gets spent rather than invested.

What’s The Real Difference?

Earning 8% (for example) on investments is great, but remember that money left on the loan is costing you 4% (in the above example). So the gain is only 4% initially. The question turns into whether or not you want to chase an additional 4% – not guaranteed – or pay off the mortgage to save a guaranteed 4%.

How About Taxes?

Gains on the sale of a primary residence are currently tax-free up to $250k for an individual or $500k for a couple. When you sell the house, if your gains are less than those limits, you owe no taxes. Of course, if you never sell the house you also owe no taxes.

Investments are taxed at capital gains rates. Yes, the lowest tax brackets could potentially have a zero rate, but more often the capital gains are taxed at 15% (or 20% depending on income). Including taxes in the equation means the gap between mortgage pre-payments and investing returns shrinks, making the true gain over time closer for each option.

A more likely answer to the original question of whether to pay the mortgage faster or invest the money would be: Do both. Look at your overall financial plan and determine the best use of your resources. It’s all about maximizing your money within your personal situation.

Wrapping It All Up

I hope this lesson on mortgage amortization has been helpful. Knowledge is power so keep this information in mind when buying a home or deciding a payment plan for your existing home. As a fee-only financial planner, I would love to speak with you if you need help. Working through this type of exercise as part of an overall larger financial life plan is what I do. Start Here to see how we can help you maximize your money to achieve your personal goals.

Question? Comments? Let me know in the comments section below.