Amortization is the process of reducing a debt over time, most often with a fixed time schedule of payments. A straight line amortization schedule reduces the debt with equal principal payments. A mortgage style amortization schedule reduces the debt with equal payments that include principal plus interest. At the beginning of the loan, the loan payments will be heavier on interest than principal. As the loan matures, the loan payments will start to apply more towards the principal.
A mortgage style amortization schedule is the loan pay-off schedule usually associated with residential mortgage loans. Let's say you borrow $100,000 to buy a new house, and you decide you want to pay it off over 30 years. A mortgage style amortization schedule divides the loan into 360 equal monthly payments. Consulting a mortgage loan payoff calculator, you see that if the interest rate is 5.7 percent, each monthly payment is $580.40. The first month's payment consists of $475.00 in interest and $105.40 in principal.
Straight Line Amortization
A straight line amortization schedule divides the principal into an equal number of payments, then adds the interest due to each month's repayment amount. If you borrow $100,000 and repay it over 30 years, each month's principal repayment will be $100,000 divided by 360, which is $277.78 each month. Consulting a straight line amortization schedule, you find that your first payment includes $473.68 in interest.
Mortgage-style amortization gives you a payment schedule that is the same every month. Also, most families have household income that rises over time. In addition to predictability, the big advantage of a loan with equal payments is the greater affordability over a straightline loan, where the payments are highest at the beginning when most families can afford it least.
The big advantage of a straightline amortization loan is that it cuts down your interest charges substantially. Over 30 years, the mortgage style loan accumulates $108,944.40 in interest charges – more than half your total payments. Over the same time period, on the other hand, straightline amortization has total interest costs of $85,262.50, a reduction in interest charges of $23,681.90.
Biweekly Payments Shorten Your Mortgage
Another repayment schedule offers the cost savings of the straightline amortization loan and the affordability of a mortgage style loan with 360 equal payments. If you borrow $100,000 at 5.7 percent annual interest and repay the loan with biweekly equal payments of $290.20 – half the monthly mortgage style amortization payment – your total interest charges will be $86,598.74, a savings of $22,345.66 over the cost of the same loan with monthly payments. You'll also pay off the loan in 24 years and nine months, five years and three months early.
Upside Down Caution
Whichever amortization loan payment you choose, you want to make sure the interest is paid in full each month. Not paying all the interest just adds to the principal amount you owe. After a period of time, you could end up owing more than your original loan amount. This is called negative amortization and means it will take longer and cost more for you to pay off the mortgage. This situation should be avoided if at all possible.
Patrick Gleeson received a doctorate in 18th century English literature at the University of Washington. He served as a professor of English at the University of Victoria and was head of freshman English at San Francisco State University. Gleeson is the director of technical publications for McClarie Group and manages an investment fund. He is a Registered Investment Advisor.