The financial milestone of buying a house comes with the financial obligation of paying the mortgage. One main concept that you should understand if you get a fixed mortgage is “amortization.”
Amortization represents the way you gradually pay down the balance on your fixed mortgage through regular monthly payments. However, it is important to realize that the amortization of your fixed mortgage is based on recalculating the amount of principal and interest you pay each month.
Interest on a fixed mortgage is not simple interest. It is interest that is paid on an annual basis. Therefore, if you have a 5% interest rate on your mortgage loan, you will be charged 5% of the loan balance each year. In actuality, you will be repaying interest each month ― so you’ll be charged 5% divided by 12 months, resulting in a monthly interest rate of 0.42%. Your fixed mortgage amortization is based on how many monthly payments you make (360 payments in the case of a 30-year fixed mortgage).
Your loan’s amortization can also be seen in a table format which shows how your fixed mortgage obligation is reduced over time. You should realize that fixed mortgages are generally set up so that the majority of your initial payments go towards interest. As the years pass, the amount going towards interest decreases and the majority of your payments will be applied to the principal loan balance. As you repay the principal, you also build home equity (i.e. ownership).
If you have a $175,000 fixed mortgage with an interest rate of 5%, your monthly mortgage payments (according to an online mortgage calculator) will be approximately $939.44 a month. Here’s how these mortgage payments break-down:
- First, you figure the monthly interest: $175,000 x 0.0042 (5% annual interest ÷ 12 months) = $735.00
- Next, subtract the interest from the monthly payment to determine how much is going towards principal: $939.44 – $735.00 = $204.44
- Finally, your new loan balance is your principal minus the amount of your payment that doesn’t go towards interest: $175,000 – $204.44 = $174,795.56
For the next month, your interest payments will be based on the new balance of your fixed mortgage. So you will have to go through calculating your payments again, this time starting out by multiplying the 0.42% rate against the new $174,795.56 principal balance (which gives you an interest payment of $734.14). Eventually, as you progress through the 360 months of your loan term, more and more of your payments will go towards reducing principal.
Many people are now asking themselves if it’s better to rent or buy a house. If you look at an amortization table on a fixed mortgage, you will see why most financial experts recommend that you buy ONLY if you plan on living in that home for a reasonable amount of time (5 to 7 years or more). Otherwise, you won’t be in the home long enough to pay down any significant portion of your principal loan balance.