Amortization: Different Mortgage Types and How It Works

For most people, the biggest investment they’ll do in their lives is buying a home or any other real estate; and that can be really expensive. Luckily, there is no need to pay the entire price upfront to purchase a property. That’s when amortization and the different types of mortgages come into play. 

This subject will be part of your real estate licensing exam, and can get complicated because of the several aspects and calculations you’ll need to learn. But, don’t worry. We are here to help you understand what amortization is and how it works.

What is Amortization in Real Estate?

In real estate, amortization is the process of paying off a mortgage loan through scheduled, periodic payments over a set period.

To clarify, a mortgage is a type of amortized loan used explicitly for purchasing real estate. So, when you take out a mortgage, you’re borrowing money from a lender, typically a bank or financial institution, to buy a property.

For a better understanding, let’s see some important concepts you’ll need to learn.

Four Main Concepts Related to Amortization in Real Estate

• Principal loan: The amount of money borrowed originally.
• Interest on the loan: The amount of money that is a percentage of the principal amount you owe the lender for making the loan.
• Interest rate: The percentage of the loan amount the lender charges the borrower.
• Amortization period: the amount of years a borrower chooses to spend paying off a mortgage.
• Amortization schedule: a loan repayment schedule through regular installments (equal monthly payments that include interest and a portion of the principal) set by lenders, such as financial institutions like banks. It details how much of each payment goes to pay the principal and the interest.

Amortization in Real Estate: Payments Over Time  

An amortization schedule is used to calculate a series of loan payments for real estate. Like a mortgage, this includes both principal (all the borrowed amount) and interest in each payment.

A unique aspect of amortization is how these payments are structured over time:

• Fixed payments: Amortization schedules usually involve fixed monthly payments. Each payment contributes towards both the principal and the interest.
• Changing composition over time: In the loan’s early years, a larger portion of each payment goes towards interest. As time progresses, the proportion shifts, and more of the payment goes towards reducing the principal.
• Full repayment: By the end of the amortization period, the entire loan is paid off, meaning both the principal and all accrued interest are fully covered.

Here is an example: Suppose you take out a $200,000 mortgage with a 30-year term at a fixed interest rate. Your monthly payments are calculated based on this principal, the interest rate, and the 30-year term.

At first, a large portion of your monthly payment goes towards interest. As you continue to make payments over the years, a larger percentage of these payments go toward the principal. By the end of the 30 years, you will have paid off the entire $200,000 plus all the interest.

How Amortization Works Depending on the Types of Mortgages

While the core idea of amortization is decreasing a loan’s balance, it works different depending on the mortgage type. This is because each one impacts the repayment schedule in a unique way. 

Let’s see these various mortgage types to understand how they work and what they mean for borrowers:

• Fixed-Rate Mortgages: These have an interest rate that stays the same throughout the life of the loan. That means the monthly payments for principal and interest remain unchanged. Here the amortization ensures the loan is fully paid off, or amortized, by the end of the term, which typically ranges from 15 to 30 years.

• Adjustable-Rate Mortgages: With them the interest rate changes over time. While the loan may start with lower monthly payments, these can increase or decrease as the interest rate changes. This affects the amortization schedule, as varying payments alter how quickly the principal is paid down. They can be a good choice if you plan to sell or refinance before the rate adjusts. However, the uncertainty of future payment amounts can make budgeting more challenging.

• Interest-Only Mortgage: In an interest-only loan, the borrower pays only the interest for a certain period, often 5-10 years. During this period, the principal balance does not decrease. After the interest-only period ends, the loan is amortized over the remaining term, resulting in significantly higher payments, as both principal and interest must be paid in a shorter time frame.

• Negative Amortization: This happens when the loan payments are set below the interest rate, causing the unpaid interest to be added to the principal balance. As a result, the loan balance can increase rather than decrease over time. This type of amortization can be risky for borrowers.

• Balloon Mortgage Amortization: This type of loan involves paying off the interest and a portion of the principal over a set period (often 5-7 years), followed by a large, or “balloon,” payment at the end of the term to pay off the remaining principal. This can be risky if borrowers are unable to refinance or make the balloon payment when it comes due.

• Graduated Payment Mortgage: With a GPM, payments start low and gradually increase, typically annually, for a set number of years. After this period, payments level off for the remainder of the loan term. This type of mortgage may lead to negative amortization in the early years if the initial payments are set lower than the interest due.

Amortization Formulas Explained

The amortization formula in real estate calculates the fixed periodic payments required to fully repay a loan over a specific period of time. Now that we know what amortization is and the main concepts related to it, let’s explain it. (However, please notice that calculating amortization is not a main objective in the real estate exam because of its complexity.)

Amortization Formula: A = P [i [(1 + i)^n] /[ (1 + i)^n] – 1 ]

• ‘A’ represents the periodic amortization payment.
• ‘P’ is the principal amount of the loan.
• ‘i’ is the periodic interest rate (for example, if the annual interest rate is 6%, then ‘i’ would be 0.06 divided by the number of payments per year).
• ‘n’ is the total number of payments (or periods).

Let’s break down the formula and solve it with an example:

Imagine you take out a mortgage loan of $200,000 with an annual interest rate of 4.5% for a term of 30 years (360 monthly payments).

Using the given formula, we can calculate the fixed monthly payment (A) required to fully repay the loan.

P = $200,000
i = 4.5% per year (or 0.045 as a decimal)
n = 30 years (or 360 monthly payments)

Plugging these values into the formula:

A = $200,000 [0.045 [(1 + 0.045)^360] / [(1 + 0.045)^360] – 1]

Now, let’s solve it step by step:

• Step 1: Calculate the numerator:

Numerator = 0.045 [(1 + 0.045)^360] = 0.045 [1.045^360]
Use: It determines the portion of the fixed periodic payment that goes towards the interest payment. 

• (1 + 0.045) : We add 1 to the decimal value of the interest rate (0.045). This step accounts for the compounding effect of interest over the given number of periods (360 months in this example). In this case, we get 1.045.
• (1.045^360): We raise 1.045 to the power of 360, as there are 360 monthly payments in 30 years. This step calculates the compound interest factor over the entire loan term. In this example, we get approximately 2.208378.
• 0.045 [1.045^360]: Finally, we multiply the interest rate per period (0.045) by the compound interest factor we obtained in step 2 (approximately 2.208378). This multiplication gives us the numerator value.

• Step 2: Calculate the denominator:

Denominator = [(1 + 0.045)^360] – 1 = 1.045^360 – 1
Use: It helps determine the portion of the fixed periodic payment that goes towards repaying the principal balance.

• (1 + 0.045): We add 1 to the decimal value of the interest rate (0.045) to account for the compounding effect of interest. This step gives us 1.045.
• (1.045^360): We raise 1.045 to the power of 360, which represents the total number of periods (monthly payments) over the loan term. This step calculates the compound interest factor over the entire loan term. In this example, we get approximately 2.208378.
• 1.045^360 – 1: After calculating the compound interest factor in step 2, we subtract 1 from it. This subtraction is done to account for the principal portion of the fixed periodic payment. By subtracting 1, we are essentially removing the principal amount from the total value.

• Step 3: Divide the numerator by the denominator:

A = $200,000 * (Numerator / Denominator)

A ≈ $1,013.37

Therefore, the fixed monthly payment for a mortgage loan of $200,000 with an annual interest rate of 4.5% for a term of 30 years (360 monthly payments) is approximately $1,013.37.

Please note that the actual calculation involves using the specific values provided and may require rounding or additional decimal places depending on the precision desired.

Summing-up

Amortization in real estate is the gradual repayment of a loan through fixed periodic payments. For all you real estate students out there, it’s not just a concept to memorize for the test; it’s a fundamental concept that plays a significant role in real estate transactions. Amortization allows you to comprehend the mechanics of loan repayment, ensuring that you can explain it confidently to your clients or colleagues.

As you study for your real estate exam, understand how the formula works, how the payments are divided, and how the loan balance changes over time. This blog is the first step in doing so. Remember, practice makes perfect!