Amortization

Definition of "Amortization"

Written by

Debran Collins

Russ Lyon Sothebys International Realty

Looking for an amortization definition? Amortization is an accounting term that basically means something like “reducing the gap between what is owed”.

Here’s the play by play: You get a $100 loan and the deal is you have to pay it back in 12 months with a little bit of interest: $10 a month is your principal. Whenever you pay $10 or more you are applying those additional funds to the amortization of your loan. As you make payments, a certain amount is applied to the principal and a certain amount to the interest. So, bringing it all home: the scheduled payment less the interest equals amortization. The loan balance declines by the amount of the amortization, plus the amount of any extra payment. If such payment is less than the interest due, the balance rises, which is considered negative amortization.

With that simple amortization definition, let’s take a look at its behavior in a real estate light:

The Fully Amortizing Payment

The monthly mortgage principal that will pay off the loan at term is called the fully amortizing payment. On a Fixed Rate Mortgage (FRM), the fully amortizing payment is calculated at the outset and does not change over the life of the loan. For example, on a FRM for $100,000 at 6% for 30 years, the fully amortizing payment is $599.56. If the borrower pays up every month, the balance will be extinguished with the 360th payment. On an ARM, the fully amortizing payment is constant only so long as the interest rate remains unchanged. When the rate changes, the fully amortizing payment also changes. For example, an Adjustable Rate Mortgage (ARM) for $100,000 at 6% for 30 years would have a fully amortizing payment of $599.55 at the outset. But if the rate rose to 7% after five years, the fully amortizing payment would jump to $657.69.

Amortization on Standard Loans

Except for simple interest loans, which are discussed below, the accounting for amortized home loans assumes that there are only 12 days in a year, consisting of the first day of each month. The account begins on the first day of the month following the day the loan closes. The borrower pays 'per diem interest' for the period between the closing day and the day the record begins. The first monthly payment is due on the first day of the month after that.

For example, if a 6% 30-year $100,000 loan closes on March 15, the borrower pays interest at closing for the period March 15-April 1, and the first payment of $599.56 is due May 1. The payment is allocated between interest and reduction in the loan balance. The interest payment is calculated by multiplying 1/12 of the interest rate times the loan balance in the previous month. 1/12 of .06 is .005. The interest due May 1, therefore, is .005 times $100,000 or $500. The remaining $99.56 is used to reduce the balance to $99,900.44. The process repeats each month, but the portion of the payment allocated to interest gradually declines while the portion used to reduce the loan balance gradually rises. On June 1, the interest due is .005 times $99,900.44, or $499.51. The amount available for reducing the balance rises to $100.06. While the principal is due on the first day of each month, lenders allow borrowers a 'grace period,' which is usually 15 days. A payment received on the 15th is treated exactly in the same way as a payment received on the 1st. A payment received after the 15th, however, is assessed a late charge equal to 4 or 5% of the payment.

Amortization Schedule

Schedules prepared by lenders will also show tax and insurance payments if made by the lender and the balance of the tax/insurance escrow account. It’s encouraged to develop an actual amortization schedule, which will allow you to see exactly how it will work.

Principal Rigidity

If you default your amortization, your credit score will likely take a hit. The payment requirement of the amortization of your standard mortgage is absolutely rigid. Skip a single one and you accumulate late charges until you make it up. If you skip May, for example, you make it up with two payments in June plus one late charge, and you record a 30-day delinquency in your credit file. If you can't make it up until July, the price is three payments plus two late charges plus a 60-day delinquency report in your credit file. Falling behind can be a slippery slope.

So, as you can see, while there’s a very basic amortization definition, there is a lot of depth to its unfoldings. It’s important to beware of the correct strategy so you don’t end up having to take care of the amortization of your pockets because of the amount of debt you will accrue by failing to pay up your principal.