Posted on August 11, 2015 - 12:58 PM
by Natasha Hunter
Amortization is the basis of all real estate finance, and often misunderstood.
This really is at the heart of all real estate finance since amortization calculations show how the entire loan is structured. Changes to the various inputs such as interest rate, time period for repayment, and loan amount can make big differences in buyer affordability.
Government regulators also feel basic amortization is important for buyers to understand. The Loan Estimate that buyers receive as part of the new RESPA-TILAIntegrated Disclosures now includes the accumulated principal and interest that will have been paid at the loan's 5-year point, giving them more perspective on how their payments are applied.
It is the gradual paying of debt by making equal, scheduled payments that are applied to both principal and interest.
For today's discussion, we'll use the 30-year fixed rate conventional conforming mortgage as our example. Most ARMs (Adjustable Rate Mortgages) are also calculated on 30-year amortization, even though the rate adjusts each year after the initial fixed rate period.
The payment schedule of a fully amortized mortgage loan in the US includes a few different figures:
- Current principal balance and monthly payment amount
- Portion of each monthly payment applied to principal
- Portion of each monthly payment applied to interest
- Outstanding principal balance after each payment is applied.
This becomes the following month's principal balance on
which interest is charged
Fully amortized means that payments are calculated to fully pay off the entire loan (both principal and interest) when the final payment is made.
For a loan calculated with 30-year full amortization, all principal and interest is paid off with the 360th monthly payment.
On a loan calculated with 15-year amortization, all principal and interest is paid off with the 180th monthly payment.
If a balance is still owed after the last loan payment is made, that loan is NOT fully amortizing.
An example of this is an interest-only loan in which the entire principal balance comes due after 3 years of paying only interest, with NO principal repayment during that time.
Here are a few important points about amortization:
- Each monthly payment pays the interest portion first,
with the remainder going to principal (adding a little
extra each month always goes to principal).
- The interest rate is an annual percentage, yet is
compounded and paid monthly on the outstanding
principal balance (5% annually = .416% monthly).
- The loan amount (original principal) is stretched out
over the amortization term of the loan.
- As payments reduce the outstanding principal
balance, the owner's equity increases.
- The same percentage interest is charged on a smaller
principal balance each month, so the payment's
interest portion decreases.
(For mathematical example and illustration only)
The first scheduled payment pays a lot of interest and just a little principal, while the last payment does just the opposite - lots of principal and very little interest.
Here it is expressed another way. This is an example of a shortened amortization schedule. An actual one includes all individual monthly payments -
(For mathematical example and illustration only)
Note that the monthly payment amount remains the same for the entire loan period, while the principal and interest portions of that payment change.
A properly structured mortgage is much more
than just a way to buy a home.
The right combination of loan program, rate, LTV, and terms can help buyers integrate their home buying with the rest of their family finances.
As mentioned up top, the CFPB (Consumer Financial Protection Bureau) also feels that buyers need a basic knowledge of amortization as it applies to their specific mortgage terms.
To help buyers be more aware of how their payments are applied to their loans, the new Loan Estimate of RESPA-TILAIntegrated Disclosures includes a snapshot of how much interest and principal will have been paid after making monthly payments for the first 5 years.
Have your buyers call me when they want to use financing and would like to know the options available to them.
Well-informed buyers make our trip to the closing table that much smoother.
Let me reinforce the trust
your buyer has placed in you! sm
All information provided by Chris Carter. See contact information below.
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