In real estate, amortization refers to the process of paying off a mortgage loan over time through regular payments. The payments are typically made on a monthly basis and consist of both principal and interest. As the loan is paid down, the amount of interest paid decreases and the amount of principal paid increases. This process is known as amortization, and it results in the mortgage being fully paid off at the end of the loan term.

An amortization schedule is a table that shows the breakdown of each payment, including the amount of interest and principal paid. As time goes on and more payments are made, the amount of interest paid decreases and the amount of principal paid increases. This results in the loan balance decreasing over time, until it is fully paid off at the end of the loan term.

The amortization period is the length of time it will take to fully amortize the loan, which is typically 15 or 30 years for a residential mortgage. However, the term of the loan can vary depending on the type of loan and the lender’s terms.

There are different types of amortization method such as:

  • Constant amortization, payments remain the same throughout the loan term.
  • Graduated amortization, payments start low and gradually increase over time.
  • Negative amortization, payments are not enough to cover the interest due, so the loan balance increases rather than decreases.

Constant amortization

This means that the payments made towards the loan remain the same throughout the loan term. The payment amount is determined at the time the loan is originated and is based on the loan amount, the interest rate, and the loan term.

The constant amortization method is based on the idea that the borrower will make equal payments over the life of the loan. Each payment is allocated towards both the interest and the principal, with the proportion of interest and principal changing over time. In the beginning, a larger portion of the payment goes towards interest and a smaller portion toward the principal. As the loan is paid down, the interest portion of the payment decreases and the principal portion increases.

The constant amortization method is often used for fixed-rate loans, since the interest rate remains the same throughout the loan term. This allows the borrower to budget for the same payment amount each month, making it easier to plan for and manage their finances.

The amortization schedule for a constant amortization will show the breakdown of each payment and the remaining balance of the loan over time. It can be a useful tool for borrowers to understand how their payments are being allocated and to track the progress of paying off the loan.

Graduated amortization

This means that the payments made towards the loan start low and gradually increase over time. This type of amortization is often used for adjustable-rate loans, where the interest rate may change over time. The loan payments start low, but as the interest rate increases, so do the payments.

The graduated amortization method is based on the idea that the borrower’s income will increase over time, allowing them to afford higher payments. Each payment is allocated towards both the interest and the principal, with the proportion of interest and principal changing over time, similar to constant amortization.

The graduated amortization schedule will show the breakdown of each payment and the remaining balance of the loan over time, as well as the increasing payments. The graduated amortization method can be a useful tool for borrowers who expect their income to increase over time, or for borrowers who are looking for a lower initial payment.

It’s important to note that this type of amortization is less common and considered risky for borrowers as the increase of payments over time can become unaffordable for the borrower if their income doesn’t increase as expected.

Negative amortization

This type of amortization occurs when the payments made towards the loan are not enough to cover the interest due on the loan. As a result, the loan balance increases rather than decreases. This type of amortization is typically used for adjustable-rate loans, where the interest rate may change over time, and the payments may not be enough to cover the interest.

With negative amortization, the borrower pays less than the required monthly payment, which results in the unpaid interest being added to the loan balance. This causes the loan balance to increase, rather than decrease as it does in traditional amortization.

For example, if a borrower has a loan with a $1,000 monthly payment and an interest rate of 5%, the payment would not be enough to cover the interest due on the loan. As a result, the unpaid interest would be added to the loan balance, causing the loan balance to increase.

Negative amortization can be a risky option for borrowers because it can cause the loan balance to increase to a point where it becomes unaffordable to repay. It can also lead to a situation called “payment shock,” where the borrower is required to make a much larger payment than they have been used to in order to pay off the loan.

Negative amortization loan are less common now days due to the risks they pose to the borrower and they have been regulated by the government.