Amortization is a term associated with mortgage loans and is mainly used in relation to loan repayments. Technically defined, amortization is an accounting method in which expenses are accounted for over the useful life of the asset rather than at the time they are incurred. Amortization is similar to depreciation in that the value of the liability (or asset) is reduced over time. Simplified in terms of a mortgage, amortization is a payment each month that combines both interest and the principal amount and is paid over a specific period of time. The concept of amortization can seem complex and understanding the process is essential to becoming an informed borrower.
The simplest way to explain the difference between amortization and depreciation is understand the type of the financial events that they are associated with. Depreciation is a term used to define an asset (cash or non-cash) that loses value over time. Mortgage amortization is the periodic reduction of the principal balance of a home mortgage that is usually fixed in the terms of the loan.
For the purposes of a home mortgage, amortization is the reduction of the principal or capital on a loan over a specified time and at a specified interest rate. Interest is the fee paid by the borrower to reimburse the lender for the use of credit or currency. At the beginning of the amortization schedule a greater amount of the payment is applied to interest, while more money is applied to principal at the end. In other words, a borrower will start out paying mostly interest and in the end the majority of the monthly payment goes toward cutting down the actual loan amount.
A mortgage is amortized when it is repaid with periodic payments over a defined term. The goal is for the mortgage to be fully amortized, an elaborate way of saying paid off, at the end of the term of the loan. As more and more of the principal is paid down, the interest declines, leading to greater mortgage amortization in the later years of the loan and a subsequent increase in the borrower’s equity in the property.
One thing to consider when taking out a mortgage is the amount of money which will be paid out over the life of the loan. A mortgage calculator which provides an estimate of monthly payments and amortizations can make it easier to see the entire schedule and impact to the borrower. Negative amortization, which can occur in financing instruments like a balloon loan, exists when the monthly mortgage payment is not big enough to cover the full amount of interest due.
The process of amortization is an easy one to understand once you know the basics and get the idea of how it all works. Mortgage amortization, as used in real estate, is when the principal balance on a mortgage is reduced over time as the home owner makes monthly payments. Amortization describes the process of paying off a loan in regular, typically monthly, installments. As a general rule, amortization is desirable, because if a mortgage is not amortizing, it means that the borrower is not making any headway on the loan.
Watch the video related to loan amortization
See the Beauty of the PMT function and an Amortization Table. For consumers, you can see how much the bank takes from you each month as interest and how much is left over for the loan reduction. For accountants (financial and tax), you can see how much of each cash flow goes toward an Expense and how much reduces the liability by. For financers, you can see how much of the cash flow actually reduces the liability by and how much the deduction on a tax form would be….
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About Author
Bill leverages his 18 years of experience in the financial services industry to write informative articles for the non-industry reader. His website is www.hotmortgagedeal.com
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