When you take out a mortgage, you’ll have to make monthly payments that will go toward both principal (the amount you borrowed) and interest. The portions that are applied to principal and interest will change over time. The process of paying down your loan balance is known as amortization.
Understanding Amortization for Mortgages
With a fixed-rate mortgage, the sum that you’ll pay each month for principal and interest will stay the same for the life of the loan (unless you refinance). The way that each payment is split between principal and interest will gradually change.
When you begin to pay off your mortgage, most of the money that you send each month will go toward interest, and only a small portion will be applied to principal. As time goes on, more of each payment will cover principal.
This means that in the first several years of your repayment period, you’ll slowly chip away at your loan balance and gradually build equity. As the years go by, you’ll reduce your principal balance and build equity at a faster rate.
Your lender will provide an amortization schedule that shows how much of each payment will go toward your principal balance and how you will pay off the loan and build equity over time. The amortization schedule assumes that you will consistently make monthly payments for the amount due.
With an adjustable-rate mortgage, you’ll have a fixed interest rate for a period of time. After that, the rate will periodically adjust. An adjustable-rate mortgage also amortizes over time, but you won’t know up front how much of each monthly payment will go toward principal and how much will cover interest. Your lender will provide updated information on amortization each time the interest rate resets.
Why Your Amortization Rate Matters
It’s important to understand how quickly (or slowly) you’re paying off your loan and building equity because that can affect your financial options in the future. If you want to refinance your mortgage or take out a home equity loan or line of credit, you’ll need to have a minimum percentage of equity and meet other requirements.
How to Build Equity Faster and Reduce Interest Payments
If you would like to pay off your principal balance ahead of schedule and save money on interest, you can make extra payments. That will allow you to reduce your principal balance faster and pay less for interest over the life of the mortgage. Before you make extra payments, check to find out if your lender will charge a prepayment penalty.
Loans with a shorter term require higher monthly payments, but they have lower total interest charges. If you take out a 15-year mortgage, you’ll have to pay more each month than you would with a 30-year loan, but you’ll pay down your principal and build equity faster. You’ll also save money on interest since a 15-year loan generally has a lower interest rate than a 30-year mortgage, and you’ll be paying interest over a shorter time frame.
