When you apply for a mortgage, your lender will provide you with an amortization schedule.

In fact, any loan you take out that has a repayment schedule, whether for a car, house or other purpose, has an amortization schedule.

Here's what you need to know about amortization before applying for any type of loan, especially a mortgage.

What is mortgage loan amortization?

Amortization is the process by which a loan’s principal balance decreases with each payment. An amortization schedule is a table that shows how much of each payment goes toward reducing the loan’s principal and how much pays interest. A mortgage amortization schedule shows your decreasing mortgage balance after each payment, as well as how much of each payment goes toward interest.

Amortization shows you will pay more interest up front

If you have a 30-year mortgage, the amortization schedule will show you what your principal balance will be after each one of your 360 monthly payments, assuming you make the minimum principal and interest payment required by the lender. A 15-year mortgage amortization schedule shows your remaining balance after each one of 180 monthly payments.

In a traditional mortgage, you will pay the most amount of interest in the first years of the loan. Your initial payments will reduce your principal balance by very little.

The reason is because the interest charged to your loan is calculated on the present balance. The longer you make payments, the less the amount of interest is required with each payment because your mortgage principal will be smaller.

The difference in amortization between 30-year and 15-year loans

For example, if you borrowed $300,000 on a 4-percent, 30-year mortgage, your monthly principal and interest payment, which doesn’t include property taxes and insurance, would be $1,432.

In the first year of the loan, you would pay almost $12,000 in interest while paying down about $5,300 in principal. In year 15, your monthly payments would reduce your principal by $9,240, while accounting for $7,947 in interest. In year 30, your interest payments would only amount to $367.

If you maintained the loan for the entire 30-year term, your total principal and interest payments would add up to $515,609.

If you opted for a 15-year fixed loan at 3.25 percent, your monthly principal and interest payment would be just over $2,100.

Even in the first year under this arrangement, you will pay down more principal ($15,780) than you will in interest ($9,500). By the 10th year, your monthly payments will reduce your principal by more than $21,000 while accounting for just over $4,000 in interest.

If you maintained the loan for the entire 15-year term, your total principal and interest payments would add up to about $379,500.

Why you need to understand loan amortization

One of the reasons it’s important to review your mortgage amortization schedule is to understand what your principal balance will be in a given year. This is especially true if you may own the home for a few years before you either have to move for career reasons or want to upgrade to a nicer home.

For example, assume you obtained a physician mortgage loan, on a $300,000 home with no downpayment. As with the example above, you receive a 4 percent mortgage rate on a 30-year fixed loan.

After the first year, you will still owe nearly $295,000 on the original loan. After five years, assuming you made just the minimum payment each month, you would have a mortgage balance of about $271,340.

If you plan to sell the home after those five years, you would have to get enough to cover the mortgage balance plus the costs incurred in selling a home, which include the commission for your real estate agent. Those costs typically equal 10 percent of the amount the property sells for.

So if you sold your home for $325,000, it would cost around $32,500 to pay your real estate agent fees and other settlement costs. After deducting the remaining mortgage balance of $271,340, you would be left with a profit of $21,160.

However, what would happen if your home fails to appreciate in value during those five years and you’re forced to sell it for the amount you originally paid for it? After subtracting $30,000 for settlement costs, you would actually have less money left over ($270,000) than what you would need to pay off your mortgage ($271,340).

On the other hand, under the 15-year option, your mortgage balance after 10 years would only be $215,700.

Use the amortization schedule to weigh your mortgage options and to help you better plan for your future as a homeowner.

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