What is Amortization and How Does it Work?
Loan amortization, in relation to a mortgage loan, is the liquidation of a debt over a period of installments. In other words, if you are buying property with a loan, each time that you make an installment payment a portion will go to the principal (the actual loan amount) and the remainder will go to interest (the fees paid to the lender for the loan). When you reach the final payment, all of the interest and principal due on the loan will no longer exist and you will own the property free and clear. Once the principal is reduced to zero, you no longer own the bank any money and you never have to answer to the lender again.
What is the Difference Between a 15, 20, and 25 Year Amortization?
You may think that choosing a longer loan term will save you money. When you consider the amount of interest that is paid each installment, choosing a longer term when investing in real estate for profits may actually damage your profits over time. While you are reducing the amount of principal you will pay each installment, you are also increasing the amount of interest that will go to the lender.
Historically, the standard amortization period for a home loan is 25 years. If you choose a shorter amortization period, say 15 years, you will be mortgage-free sooner. The interest paid over the life of the loan is also greatly reduced. A comparison chart shows that you will save money that you are handing over to the bank when you opt for a 15 year period as opposed to a 25 year period. On a $100,000 loan with 6% interest, you will save $1928.40 just in interest alone compared to a 25 year period.
Why Mortgage Lenders will Use Longer Periods to Maximize Their Profits
As you can see, choosing a shorter term will save you money. A mortgage lender offers longer terms because investors see the smaller payment and automatically assume the longer term is the most practical option. What some investors may not realize is that they are saving money by choosing the shorter term. Most lenders will charge higher interest rates for a loan with a 25 year amortization. The reason for this is that they are carrying you on the books longer and consider you a higher risk. You are also paying this higher interest for an additional 5 or 10 years. This means that the bank will encourage you to choose longer periods to maximize their profits.
Save on Your Investments by Understanding Amortization
If you can comfortably afford the higher mortgage payments, choosing a shorter amortization period is the key to saving on your real estate investments. Remember that you do not have to stay with a long period for the whole life of your loan if you do not want to. Shorten your amortization period, pay off your loan faster, and reduce the amount of interest you are paying the bank. The faster you have your first property paid off, the faster you can move on to the next one!
Andrew Jameson is a real estate financier and mortgage broker that loves his career, his family and helping other make money through real estate. To get a better handle on how amortization is affecting your mortgage or loan, check out the excellent amortization calculator at GetAmortized.com. Thanks for visiting and for reading this post!