Depending on your mortgage’s interest rate and the length of the loan, the amount you pay in interest could very well exceed the amount you originally borrowed. Understanding amortization, or how the loan is calculated, is the first step in learning how to reduce the amount of interest you pay while shortening the length of your mortgage.
Although the concept of mortgage amortization is simple, the actual formula is fairly complicated. Simply put, amortization is a process in which you gradually reduce the amount you owe on a loan while paying interest on the remaining balance through a payment schedule set forth by the lender.
Lenders commonly structure repayment schedules based on 12 monthly payments per year. These loans are recalculated each month by multiplying the remaining loan balance times 1/12 of the interest. If your mortgage has a 6.0 percent interest rate, multiply the principal each month by 1/12 of 6.0 percent, or 0.5 percent, to determine how much you owe in interest. The first payment for a $200,000 mortgage at 6.0 percent, for example, would apply $1,000 toward the interest and the remainder of the payment, $240.31, towards the principal, reducing the original loan amount to $199,759.70. The next month, multiply $199,759.70 times 0.5 percent to determine the new interest amount.
Mortgage Amortization vs. Simple Interest Amortization
Unlike traditional mortgages, most other personal loans, including car loans, amortize using simple interest calculations. These work very much like a mortgage amortization, only lenders calculate the interest daily rather than monthly. Using the previous example, divide the 6.0 percent interest rate by 365 to determine the amount of interest charged each day. The monthly vs. daily interest calculations explain why mortgage lenders often give you a grace period after the due date to make a payment, while it is imperative that you pay simple interest loans on or before the day they are due.
Two common types of mortgages are fixed-rate and adjustable-rate mortgages (ARMs). When you take out a fixed-rate mortgage, you lock in the interest rate for the life of the loan. With an ARM, lenders can change the interest rate periodically. Many ARMs come with flexible payment options that allow you to keep low payments despite increases in the interest rate. In this case, it is possible that one or more of your payments does not cover the interest that you owe the lender that month. The difference between the amount owed and the amount paid is tacked onto your balance, resulting in a situation called “negative amortization.” Instead of your principal decreasing as you make payments, it can actually increase over time, according to MSN Money.
The Bottom Line
Because of the way amortization of a mortgage works, the amount paid toward principal each month holds the key to how much interest you will pay going forward. Any time you pay an additional amount toward the original loan balance, you reduce the amount of interest you will accrue over the life of the mortgage and the length of the loan, and thus the total amount you will pay for your home.
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