Amortization 2


Definition of "Amortization"

The repayment of principal from scheduled mortgage payments that exceed the interest due. The scheduled payment is the payment the borrower is obliged to make under the note. 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 negative amortization. The Fully Amortizing Payment: The monthly mortgage payment that will pay off the loan at term is called the fully amortizing payment. On an 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 makes that payment 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 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 payment 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. Readers are encouraged to develop an actual amortization schedule, which will allow them to see exactly how they work. They can do that using one of my calculators. Payment Rigidity: The payment requirement of the standard mortgage is absolutely rigid. Skip a single payment 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. Amortization on a Simple Interest Mortgage: On a simple interest mortgage, interest is calculated daily based on the balance on the day of payment, rather than monthly, as on the standard mortgage. A borrower who pays on the first day of every month in both cases would come out the same over the course of a year. But borrowers who pay late while staying within the usual 15-day grace period provided on the standard mortgage, do better with that mortgage. If they pay on the 10th day of the month, for example, they get 10 days free of interest on the standard mortgage whereas on the simple interest mortgage, interest accumulates over the 10 days. Similarly, borrowers who make extra payments of principal do better with the standard mortgage. For example, if they make an extra payment of $1,000 on the 15th of the month, they pay 15 days of interest on the $1,000 on the simple interest mortgage, which they would save on a standard mortgage. The only borrowers who will do better with the simple interest mortgage are those in the habit of making their monthly payments early. If you make your payment 10 days before it is due, you will receive immediate credit with the simple interest mortgage, saving the interest on the portion of the payment that goes to principal reduction for the 10 days. With the standard mortgage, a payment received 10 days early is credited on the due date, just like a payment that is received 10 days late.

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