Amortize Details

There are three important parts of a loan: schedule, interest, and principal. The schedule is everything related to time. The interest rate is the added percentage of the total value loaned to the borrower. A principal is the amount of money the borrower initially applies for the loan. If you apply for a $20k loan, then the principal is $20k.

When you're paying for a loan, the lender bills you monthly with a certain amount of money. The monthly payments are made out of principal cost and interest cost. But here's the thing: borrowers used to force lenders to fully pay the interest fees first so that they can flip the mortgage to another company after the interest fee is fully paid. This unethical practice makes customers unwilling to apply for a loan, which stifles the mortgage industry's growth.

Amortization was the answer to this practice. Amortization splits the monthly payment in two, one for principal cost and another one for the interest cost. Usually, the amortization rate would be 90% interest cost and 10% principal cost on the first monthly payment. As time goes on, the interest cost will lower while the principal cost will go up on each monthly payment until the payment ends with a 10% interest cost and 90% interest cost.

Example of Amortization

Let's say we're applying for a fully amortized loan worth $100.000 with a 4% fixed annual interest rate, and the loan term is 30 years. The total amount you have to pay for the entire loan is $171.867, with $100.000 being the principal cost and $71.867 being the interest cost. To calculate our monthly payment, we have to divide the entire loan amount by 360 (months), which results in $477 per month.

Because the loan is fully amortized, the $477 monthly payment is made out of a sum between interest cost and principal cost. Different moneylenders have different amortization ratios, but it usually lies around 90%-70% of the interest cost at the first payment, then it gradually goes down. Assuming we're following the 70%-30% rule, the monthly payment of $477 is made out of $333 interest cost and $144 principal cost. Once you paid your first monthly payment, your principal balance goes down to $99.855 (from $100.000), and your interest balance goes down to $71.534 (from $71.867).

At the 180th payment (15th year), your payment would still be $477, but it has a different combination of interest and principal cost. Your $477 monthly payment is made out of $261 principal cost and $216 interest cost. As you can see, the interest cost percentage has lowered down from 70% to around 45%, while the principal cost percentage has risen from 30% to around 55%. Your final monthly payment would be $474, consisting of $472 principal cost and only $2 interest cost.

Significance of Amortization

Mortgage and loan business used to be full of unscrupulous practices: 5-year maximum loan term, massive monthly payment, lack of insurance, unreasonable interest rates, etc. However, they soon realized that these practices wouldn't be profitable in the long run.

Fully-amortized loans solved this problem. By spreading the interest cost and principal cost, fully-amortized loans also spread the risk of mortgage failure evenly on both lender and borrower. This also allows the lender to offer a much longer loan term (up to 30 years) because the inherent risk is very low. As a result, borrowers can enjoy a significantly lower monthly payment.

All these effects make the fully amortized loan much more economically viable, which increases its popularity even more. As a result, the mortgage and loan business is thriving because both parties benefit from the fully amortized loan system.