Mortgage Amortization: The Dance Between Principal and Interest

Knowing mortgage amortization when taking out a home loan is optional, but understanding it helps. It allows you to plan accordingly, whether you intend to pay off your debt early or refinance to get a better deal in the future. Learn how it works, how to calculate it and more.

What Is Mortgage Amortization?

Mortgage amortization is the process of zeroing out your home loan by making a series of fixed payments. The amortization schedule depicts how your principal balance decreases over time and the monthly interest amount you pay.

This table shows installments of the same amount based on your mortgage term. If you have a 30-year mortgage, your amortization schedule consists of 360 installments because you need to repay your loan over 360 months. If you have a 10-year loan, the schedule only has 120 installments.

One portion of every installment goes toward the principal, while another goes toward interest. However, the split isn’t 50/50. Your outstanding principal balance determines the amount of interest that makes up the next installment. The higher your interest amount, the less money you have left to pay off your principal balance.

If you borrow a significant sum to buy a house at a high interest rate and agree to repay it for a lengthy term, a large chunk of your early monthly mortgage payments will go toward the interest.

What Are the Benefits of Mortgage Amortization?

Amortizing your mortgage debt and its associated interest is beneficial for many reasons, including:

• Transparency: An amortization schedule clearly shows how much of your installment goes toward the principal and interest. This information lets you crunch the numbers, ensuring your lender correctly charges you based on the agreed-upon interest rate.
• Strategy: Seeing the interplay between principal and interest allows you to make informed financial decisions to minimize your expenses when deciding how much to put down, resetting your mortgage’s clock through a refi or prepaying your loan.
• Manageability: Fixed repayment installments make personal finance management easier. The better you can manage your finances, the more effectively you can avoid falling into arrears, improve your creditworthiness and build equity quickly.
• Predictability: Knowing how much your mortgage costs monthly gives you peace of mind. Predictable housing costs simplify budgeting, helping you control your spending and set aside cash for emergency, leisure, and retirement.

Is Monthly Amortization the Same as Monthly Payment?

Generally, no. The amortization schedule illustrates only two out of the four components of your monthly mortgage payment. It excludes the property tax and homeowners insurance premiums, which may change periodically. Your lender sets up an escrow account where you contribute funds to cover these costs.

The variability of the property tax and homeowners insurance premiums can make budgeting for your housing costs more challenging. Plus, you can only avoid them in certain situations, like qualifying for a homestead tax exemption, so they render your monthly mortgage payments less predictable unless you pay them separately.

However, paying your property tax and homeowners insurance separately presents unique challenges. You risk missing your payments by being clueless about how much you owe, forgetting when they’re due or not knowing how to pay them. In contrast, your lender pays these bills directly using your monthly escrow contributions.

How to Calculate Amortization

Learning how to calculate your monthly mortgage repayment installment, principal payment and interest amount matters when creating an amortization schedule from scratch or verifying the copy your lender gave you at closing.

How to Calculate Your Monthly Mortgage Repayment Installment

The calculation involves a fraction, so you must first calculate the numerator and the denominator using a scientific calculator.

Using a hypothetical scenario of a 15-year $300,000 mortgage at 3% interest, calculate the numerator using this formula:

1. Divide 0.03 — the annual interest rate in decimal form — by 12 to find the interest rate for each month, which should be 0.0025.
2. Add one, so it should be 1.0025.
3. Raise the sum to the power of 180 — the total number of installments in a 15-year loan — and the answer should be 1.5674317246680084806453692952484.
4. Multiply the number by 0.0025 to determine the numerator, which should be 0.00391857931167002120161342323812.

Here’s the formula for the denominator: 

1. Add one to 0.0025.
2. Raise the sum to the power of 180, and then subtract one. Your denominator should be 0.56743172466800848064536929524843.

Here’s how to calculate the monthly mortgage repayment installment:

1. Divide the numerator by the denominator, so you should have 0.00690581640277990040397627174213.
2. Multiply the quotient by the loan amount, which is 300,000. Round the product to the nearest hundredth to get 2,071.74. Your mortgage’s repayment installment is $2,071.74.

How to Calculate Your Interest and Principal Payments for the Month

Using the same hypothetical scenario, here’s the formula to calculate how much of your first monthly payment on your amortized mortgage goes toward the interest and principal:

1. Multiply 0.0025 by 300,000 — the outstanding loan balance. You should get 750, which is your interest payment.
2. Deduct 750 from 2,071.74, your monthly mortgage repayment installment, to get 1,321.74, your principal payment.

Excluding the property tax and homeowners insurance premiums, 36% of your monthly mortgage payment goes toward paying interest and the other 64% reduces your principal balance.

Next month, less of your monthly payment should go toward the interest since its basis, your outstanding principal balance, would be lower. Your loan would progress this way until paid in full at the end of your term — or sooner, if you prepay your mortgage ahead of schedule.

Making a payment between monthly due dates has a compounding effect. One hundred percent of the funds would directly go to the principal, indirectly reducing your future interest payments.

What Is the Difference Between Simple Interest and Amortization?

Simple interest and amortization are unrelated concepts, but not mutually exclusive. Simple interest is a method of calculating interest in which the unpaid interest accumulates in a separate accrual account instead of being added to the principal balance. The outstanding principal balance freezes without paying off the unpaid interest first. On the other hand, amortization is the process of spreading your repayment installments in equal amounts over the life of the loan.

The opposite of a simple interest loan is a compound interest loan, where the unpaid interest adds to the principal, causing you to pay interest on unpaid interest. Amortizing mortgages use simple interest, except when they allow negative amortization — a term describing loans whose principal balances increase due to unpaid interest.

Use Your Mortgage Amortization Knowledge to Borrow Wisely

Understanding this concept informs you of every decision’s risk and reward. Master how amortizing mortgages work to be a financially savvy homebuyer.