When you finance the purchase of a property through a lender, you take out a type of amortized loan known as a mortgage. What is amortization definition? Glad you asked.
Definition of Amortization: The process of repaying a loan in fixed, regular payments according to a predetermined schedule.
With a fixed-rate amortized loan, your payment amount remains the same each month. However, the amount of money you’re paying towards the principal, interest, and other expenses changes over time.
At the beginning of repaying your loan, the interest costs of the loan are at their highest. As you move towards your last loan payment, the amount that you pay towards interest will be proportionately lower.
Understanding amortization can help you create a repayment schedule that is most advantageous to your financial health and investment goals. Let’s take a look at what you need to know about amortization.
You can either use a loan amortization calculator to calculate your loan amortization schedule or you can do so by hand. In the first method, you just need to enter the loan term, principal, and interest rate into a loan amortization calculator.
For the second method, you can determine the monthly principal due on amortized loans with a relatively simple formula.
First, you will take your interest rate and divide it by 12 for the 12 months of the year. Then, multiply this quotient by your outstanding loan balance. Finally, take this product and subtract it from your total monthly payment.
This will leave you with the monthly principal due on your amortized loan.
There are a number of different types of amortized loans, including auto loans and personal loans. Home loans are commonly 15-year or 30-year fixed-rate mortgages, which means you make equal monthly payments that follow a fixed schedule or amortization. However, adjustable-rate mortgages (ARMs) are a bit more complicated as your amortization schedule can be altered by your lender adjusting your interest rate.
A very useful way to visualize mortgage amortization is by looking at a mortgage amortization table. This is also referred to as a mortgage amortization schedule. This is a grid that outlines how much of each monthly payment is going towards the principal of the loan and how much is going towards the interest.
Basically, when you make monthly payments towards your loan, the balance of the loan will decrease gradually at first. A large portion of your payment will go towards paying interest, and you will therefore be building equity quite slowly.
If you maintain the same mortgage for the life of the loan (as opposed to selling the property or refinancing,) the final years of your mortgage loan involve paying more towards your principal rather than interest. This means that you will be building equity more quickly in the final years of the loan.
30-year fixed-rate mortgages are by far the most common type of mortgage available for the typical homebuyer. However, real estate investors might consider a 15-year loan for the benefits a shorter loan term offers.
There are pros and cons to each option, so each investor should consider which strategy is most harmonious with their financial needs and goals.
15-year mortgages can be appealing because it means you can pay down your debt faster. If you follow the loan repayment schedule for the property, you will pay off the property in half the time as a 30-year mortgage.
You can also typically get a lower interest rate with a 15-year loan as opposed to a 30-year loan, meaning that the amount you’re paying over the life of the loan can be quite a bit lower. In general, the interest rates for 30-year mortgages tend to be 0.5%-1% higher than those for 15-year loans.
However, 15-year loans also come with higher monthly payments. This means that they don’t provide nearly as much cash flow as a 30-year mortgage. When you are paying off your loan faster, it means that you have more capital tied up in the property rather than having the opportunity to use that capital to make other investments.
Basically, it’s possible to get a better overall ROI when you take on a 30-year mortgage as opposed to a 15-year loan. While it might seem like paying off debt faster is always better, the opportunity to cheaply leverage your money with a 30-year mortgage could be more advantageous in the long run.
There are a number of different options when it comes to amortization schedules. Understanding the differences can help you understand which loan terms are most favorable to your investment strategy.
Full Amortization With Fixed Rate
A fully amortized loan is a loan where your loan will be paid off in full by the end of the loan term if you follow the original repayment schedule. When this type of loan has a fixed interest rate, the mortgage payments you make each month will remain equal through the life of the loan. You will only experience a change in the amount of your monthly payment if your homeowner’s insurance or taxes change.
Full Amortization With Variable Rate
With this type of fully amortized loan, your monthly mortgage payment won’t stay the same every month. There is usually a teaser period at the beginning where the interest rate is on the low side. However, once this is time period is over, the loan is re-amortized in order to be paid off by the end of the term each time the principal and interest adjust.
Full Amortization With Deferred Interest
Fully amortized loans with deferred interest are loans where the interest payments aren’t charged for a set period of time. You’ll often find this type of loan offered for big-ticket items such as home appliances. However, this type of loan is also available for mortgages, known as a graduated-payment mortgage or a deferred interest mortgage.
Partial Amortization With Balloon Payment
This type of loan involves making regular monthly payments in addition to making a large lump sum payment (or, a “balloon payment”) on the loan maturity date. With this method, only a fraction of the loan’s full value is amortized.
Negative amortization is when a failure to pay the interest due on the loan increases the loan’s principal balance. These are featured in certain types of mortgage products. While this type of loan can offer borrowers more flexibility, it can be quite costly in the long run if not properly managed.
Understanding which type of amortized loan is best for your investment property can make a huge difference in your overall financial wellbeing. There are many different factors to consider when you are determining which type of loan to take out, including your desired cash flow, loan terms, and your other investment opportunities.
When you’re purchasing a rental property, it’s essential that all of the numbers add up in your favor. Don’t forget to check out our rental property calculator to help you calculate the prospects of your investment property.
Want to keep learning about the basics of real estate investing? Then learn about what capitalization rates are and how understanding them can transform your financial life. Then make sure you brush up on your knowledge of closing costs and see exactly what is included in closing costs when you buy a property.