The term ‘amortization' shares its origin with the word ‘mortgage.' Both come from the Latin root, ‘mort' which means to terminate or kill. It should be every person's goal to terminate or kill the balance on his or her home loan (mortgage); in order to accomplish this, a portion of each payment must go towards paying down the principal. Because the lenders charge interest, a portion of each payment also must go to them. In this article, I hope to help you better understand loan amortization.



Basically, loan payments are calculated by dividing the principal balance by the number of payments. Interest charges must also be added in to each payment, and therefore only a portion of each payment will apply to the principal. Each month the balance on the loan will decrease slightly. Because interest charges are a percentage of the balance, they also decrease each month. The payment amount remains constant, so it only makes sense that as more payments are made, a larger portion of each payment will apply to the principal. Amortization is this process of determining the payment so that a portion of each payment applies to the principal and a portion to interest charges.

There are a few types of loan programs that each amortizes a bit differently. There are adjustable rate mortgages (ARMs), fixed rate mortgages (FRMs), interest only loans (IO), and negatively amortizing loans to name a few.

An ARM is a loan with an interest rate that is fixed for a certain period of time, after which it becomes adjustable. Commonly, ARMs will have a period of 2, 3, 5, 7, or 10 years for which the interest rate and payment are fixed. When the “fixed period” is over, the interest rate may adjust up or down; consequently the loan will re-amortize causing the payment to also adjust up or down. For more information on ARMs, search this directory or visit the website below for my article entitled, “What's best for me – an ARM or Fixed?”

A FRM will amortize at the beginning of the loan and remain constant throughout the life of the loan. The interest rate on a FRM never changes (hence the name), nor does the payment.

Interest only loans operate just as they sound. These payments are not technically amortized, rather 100% of all payments will apply to paying off the interest charges before any principal is paid down. IO loans can be helpful in some instances, but can be problematic in others. You should consult with an honest and ethical mortgage professional to determine if an IO loan is right for you.

Negatively amortizing loans (such as the MTA Option ARM) are dangerous loans that can be quite confusing to the common consumer. These loans, namely the Option ARM, typically carry payment options. One option is to pay a fully amortized amount; this means that each payment will cover a portion of the principal and the interest charges. The second payment option is an interest only option. And the third payment option is a very small amount (allowing consumers to feel as though they can afford a house that they really cannot) that does not cover all of the interest charges. The amount of interest that is not covered by this payment is simply added back onto the loan balance (negative amortization). As a borrower pays with this option, they will see themselves going backwards in their loan. For more information on the Option ARM, search this directory or visit the website below for my article entitled, “I've been paying on my mortgage and my balance went up!?”