Owning a home can feel good. But is it a good financial decision?
There’s a lot that goes into answering that question, and one of the biggest factors is something that sounds both incredibly boring and incredibly confusing: mortgage amortization.
It’s not the sexiest financial topic in the world, but it has a big impact on your personal finances. In this post we’ll break it down so that you understand what it is and how it should factor into your decision about whether to buy a house.
What Is Mortgage Amortization?
Each time you make your monthly mortgage payment, that payment is split between paying interest and paying down principal (reducing your loan balance). Amortization is simply the process by which that split is calculated.
See, your payment isn’t split the same way throughout the life of your mortgage. It’s actually different with each payment, with your earliest payments going primarily toward interest.
For example, let’s say you buy a $250,000 house, put 20% down, and take out a 30-year, $200,000 mortgage with a 4% interest rate. That means your monthly payment would be $955.
To calculate how much of that first payment goes toward interest, you simply divide the interest rate by 12 to get a monthly interest rate and multiply that by your outstanding loan. Here’s how it looks in this example:
- (4% / 12) * $200,000 = $667
That means $667 of your initial mortgage payment is used to pay off interest, while the remaining $288 reduces your mortgage balance to $199,712.
Next month the same calculation is run again, but this time with your slightly lower mortgage balance. That leads to a $666 interest payment and $289 going toward reducing your loan.
And that’s how it works. Your early payments are primarily used to pay interest, but over time it slowly shifts so that more and more of your monthly payment is used to reduce your mortgage balance.
You should receive an amortization schedule when you apply for a mortgage, and you can also run the numbers yourself here: Zillow Amortization Calculator. This will show you exactly how much of each payment goes toward interest, how much goes toward principal, and how much interest you’ll pay over the life of the loan.
What Does That Mean for You?
Okay, great, so you have the technical explanation for how mortgage amortization works. But how is that actually relevant to you? Why should you care?
There are two big implications to keep in mind as you consider whether or not to buy a house.
The first is this is one of the reasons it often requires you to stay in your house for several years before your home purchase pays off versus renting. People often talk about renting as if you’re “throwing money away,” but they forget that you’re doing something very similar in those early years of your mortgage as well.
Remember, those interest payments you’re making, which are the majority of your early mortgage payments, aren’t building equity in your home. That money is going straight to your lender and will never be yours again. It usually takes a while before your home equity really starts to grow.
The second is buying a house costs much more than most people realize. Take the example above. You might think of it as just a $250,000 purchase, but when you include all the interest you pay over the life of that 30-year mortgage, the total cost rises to $393,739.
And that doesn’t even include the cost of homeowners insurance, property taxes, repairs, upgrades, and everything else that comes with owning a home.
The bottom line is buying a house is expensive, and in many cases renting is actually a better financial move, especially if you aren’t committed to staying in the house for an extended period of time. You can run the numbers for yourself here: New York Times buy vs. rent calculator.
How to Combat Amortization
To be clear, mortgage amortization isn’t a bad thing. It’s just how mortgages work, and it’s important to understand so you can evaluate the true cost of buying a house.
But if you’d like more of your money to go toward principal sooner, and therefore decrease the amount of interest you pay, there are a few ways to do it.
The first is to put more money down when you buy the house. That down payment is immediate equity in your home that will not be charged interest.
The second is to make extra payments and make sure they go toward paying down principal. You will have to double-check your mortgage’s specific terms, though, to make sure there aren’t any prepayment penalties or other clauses that would make this a bad idea.
And the third is to take out a 15-year loan (or other shorter term). Using the same example above and changing only the length of the loan from 30 years to 15 years, the monthly payment increases to $1,479, but the total cost of the house over the life of the loan decreases to $316,287. That’s a savings of $77,452 and doesn’t factor in the likelihood of getting a better interest rate in return for the shorter loan period.
Keep in mind all of these strategies can be beneficial in some situations and not in others. In some cases it can make more sense to invest your money elsewhere, so you’ll have to run your own numbers and make the best decision based on your personal situation.