When you take out a mortgage, you agree to pay back the loan over a set period, typically 15 or 30 years. But the way your monthly payment is split between the principal and the interest changes over time. This process is called amortization.
Disclaimer: This guide is for educational purposes only and does not constitute financial or mortgage advice.
What is Amortization?
Amortization is an accounting technique used to periodically lower the book value of a loan or an intangible asset over a set period of time. For a mortgage, it simply refers to the schedule of your monthly payments and how they are applied to your balance.
Even though your total monthly payment (for a fixed-rate mortgage) stays exactly the same every month, the composition of that payment shifts significantly from the beginning of your loan to the end.
The Early Years: Paying Mostly Interest
At the beginning of your mortgage, your loan balance is at its highest. Because interest is calculated based on your outstanding balance, a huge portion of your early monthly payments goes directly toward paying interest to the bank.
In the first few years of a 30-year mortgage, it is very common for 70% or more of your monthly payment to go toward interest, while only a small fraction chips away at the actual loan amount (the principal).
The Tipping Point
As you slowly pay down the principal month by month, your outstanding balance decreases. With a lower balance, the interest charged each month also decreases.
Eventually, you reach a "tipping point"—usually about halfway through the loan term—where more of your monthly payment starts going toward the principal rather than the interest.
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Open Mortgage CalculatorWhy Extra Payments Matter
Because of the way amortization is front-loaded with interest, making even small extra payments toward your principal early in your loan can save you a massive amount of money.
When you pay extra toward the principal, you permanently reduce the balance that future interest is calculated upon. This effectively shortens the life of your loan and skips thousands of dollars in interest payments.
Summary
- Amortization is the schedule of paying off a loan over time.
- Early payments consist mostly of interest.
- Later payments consist mostly of principal.
- Extra payments early on yield the highest interest savings.