Amortization means complete repayment of any loan and this may be accomplished by making use of a sinking fund or money set aside for such purposes. Describing the term amortization in simple words would denote that if a borrower makes regular repayments for a specific time, he or she would be able to clear off their debts absolutely.
Normally, borrowers adopt a very systematic method to repay a mortgage loan. The best way to do this is to prepare a repayment schedule on your computer and make certain that repayment made every month are matching and it includes the pay off principal sum along with the interest due on the unpaid amount of the credit. Being systematic and organized in repayment of loans will help you to evade any error or being a defaulter at any point of time.
Below is an ideal computed repayment program that will help you to understand the issue better. The repayment calendar is for 20 years for a loan worth $20,000 at 10 per cent interest rate that is compounded (interest on the mortgage loan as well as the accrued interest) twice every year. Every line in this table characterizes the payment made towards clearing the loan every month and the mount is worth $190.34.
| Payment number | Monthly payment | Interest payment | Principal payment | Balance of loan |
| 1 | 190.34 | 163.30 | 27.04 | 19972.96 |
| 2 | 190.34 | 163.08 | 27.26 | 19945.70 |
| 3 | 190.34 | 162.85 | 27.49 | 19918.21 |
| 4 | 190.34 | 162.63 | 27.71 | 19890.50 |
| 5 | 190.34 | 162.40 | 27.94 | 19862.56 |
| 6 | 190.34 | 162.17 | 28.17 | 19834.39 |
During the initial period of the loan repayment, payments made every month are basically the interest amount of the mortgage principal. However, as the loan period moves forward, the repayment made every month comprise more of the principal and lesser interest amount. Despite this change in the composition of the repayment, you will notice that the amount paid by the borrower is more or less the same, barring a little modification in the just preceding recompense (needed to check out the fractions). At the same time, make a note of the amount paid towards reducing the outstanding principal amount of this mortgage credit during the last six months.
| Payment number | Monthly payment | Interest payment | Principal payment | Balance of loan |
| 235 | 190.34 | 9.02 | 181.32 | 923.80 |
| 236 | 190.34 | 7.54 | 182.80 | 741.00 |
| 237 | 190.34 | 6.05 | 184.29 | 556.71 |
| 238 | 190.34 | 4.55 | 185.79 | 370.92 |
| 239 | 190.34 | 3.03 | 187.31 | 183.61 |
| 240 | 190.34 | 1.50 | 183.61 | 0.00 |
You have already seen that during the initial months of the loan, the repayments done each month mainly comprised the interest on the principal amount and as the credit progressed, the repayments included more of the principal and less interest. Notwithstanding this modification in the composition of the repayments made each month, it must be mentioned that the interest paid by the debtor each month is essentially the charges paid on the unpaid principal amount and has nothing to do with the accrued interest. The reason behind this change is simple. If you will notice, as the loan moves towards it's a close, the monthly repayment includes more of the principal amount and less interest as there is very little outstanding unpaid requiring the borrower to pay a lesser interest amount. In case the borrower was to repay the entire mortgage loan amount recompensing identical principal payments as well as interest on the principal every month, payments made each month would certainly differ as the table shows below.
| Principal | Interest | ||||
| 1st month: | 83.33 | + | 163.29 | = | $246.62 |
| 120th month: | 83.33 | + | 81.64 | = | $164.97 |
| 240th month: | 83.33 | + | 0.68 | = | $84.01 |
The table depicts that the borrower is required to make higher monthly payments during the initial stages of the mortgage credit, while the amount gradually reduces as the loan progresses. In actual fact, such 'uniqueness' of the monthly repayments is an noticeable downside of the amortization method. Any home owner who has secured a credit against his or her property has done so with a specific purpose and hence would be requiring more money to take care their family needs during the initial stages of the loan. Hence, the amortization method may prove to be a major disadvantage for many mortgagors.
On the other hand, as the interest rates go up in the market, the borrower is required to make higher payments to the mortgagee every month. In order to contain the monthly recompenses to the sum paid by the mortgagor in the early stages of the loan, he or she needs to extend the amortization period of the credit. Although this would ultimately make the loan more than it was at the beginning, most borrowers are not left with any other options. The table below illustrates the amount of money a borrower would actually have to pay on a loan worth $50,000 at 12 per cent interest compounded biennially if he or she decided to extend the amortization period to 15, 20 or 25 years.
While presenting the amortization calculations for 15, 20 or 25 years, the table presented below takes it for granted that the mortgage arrangement will be stable all through the loan period. Although it is unlikely that the mortgage structure will be unvarying over such a long period of time, this has been presumed to help calculate an approximate overall interest sum on the debt.
| 10 years | 15 years | 20 years | |
| Monthly payment | 590.81 | 540.49 | 515.95 |
| Yearly cost | 7,089.72 | 6,485.88 | 6,191.40 |
| Total cost | 106,345.80 | 129,717.60 | 154,785.00 |
| Total interest paid | 56,345.80 | 79,717.60 | 104,785.00 |
If a borrower has acquired the mortgage loan with a 25-year amortization period, he or she may bring down the repayment term to 15 years by making an additional payment of $74.86 every month. Adopting this measure will help the debtor or the home owner to make a substantial saving worth $48,439.20. Similarly, the table illustrates how a home owner can reduce the amortization period of the mortgage loan from 25 years to 20 years by paying an additional sum of $24.54 each month. If this is done, the borrower will be able to make a substantial saving to the tune of $25,067.40.
It is worthwhile to mention here that a borrower can make further savings by making weekly repayments against a mortgage loan. Although this facility was not available earlier, currently many prominent lenders offer this feature. At the same time, it may be emphasized here that one should not mix up the amortization or pay off of a credit with the term or credit term. Hence, when a home owner acquires a loan against his or her property with a 25-year amortization it does not denote that the term or term of the credit is for 25 years.
