If you want to understand the lending process you will need to understand the concept of amortization. Having a basic knowledge of this concept is critical because almost all the loans made available to the public today including car loans and mortgages are amortized loans.
The interest, terms and payments of most loans are based upon amortization. Indeed almost everything about the majority of loans including the terms of mortgages is based upon amortization.
Understanding amortization can help a person get a better deal on a loan and pay a better interest rate. Knowing a little about amortization can definitely help a borrower negotiate better terms for a loan.
What is Amortization
Amortization is the gradual planned reduction of capital expenses over time. Therefore an amortized loan is one that is paid off over time through a series of predetermined payments.
A good example of such a loan would be a mortgage. In the average mortgage the amount borrowed and the costs of the loan including the interest are added up into one amount. This amount is then divided by the number of payments that the borrower agrees to. The end result of this payment is the monthly mortgage payment that the borrower will make.
The reason that most loans are amortized is to make them affordable for the average person. The average person simply doesn’t have enough money to cover the cost of buying a house or a new car in the bank. On the other hand they will have the money available to make the purchase in the future.
Amortization enables people to tap into future income to make purchases today. Amortization makes it possible for middle class families to make large purchases and to have a better lifestyle. Most of us would not be able to afford homes or cars without it.
Another benefit of amortization is that it controls the cost of lending and borrowing. Generally, the interest rate on an amortized loan is locked in over the life of the loan. This allows borrowers to budget for future loan payments.
In some cases amortized loans may come with an adjustable rate. Under such a scenario the interest rate can be changed usually at a specific time. Since this is usually spelled out in the loan agreement borrowers can budget for it.
Making Amortization Work for You
Borrowers have two important tools that they can use to make amortization work for them: loan agreements and mortgage or amortization calculators.
The loan agreement spells out the terms of the loan. It should list the interest rate, the number of payments, the amount borrowed or principal, and added amounts such as insurance and closing costs. Adding up the amounts listed in the loan agreement and dividing them by the number of payments should give the borrower the amount of the monthly payment.
Multiplying the monthly payment by the number of payments will give a borrower the cost of the loan or mortgage. This will then give the borrower the final or total cost of the loan. In many cases this cost could be different from what is quoted.
Persons who are not good at math should have no problem calculating loan or mortgage costs. There are special calculators that are designed to calculate this. A person who shops around should be able to find such a calculator for sale at discount stores like Wal-Mart for under $20. There are also amortization calculation tools available for free online.
Always calculate the amortization of any loan that you take out yourself. Calculating amortization will show you the true cost of the loan and help you save money. Many people find themselves paying much more than they should on a loan because they didn’t calculate amortization.
Something else to remember is that you can pay more than the payment on an amortized loan. This goes toward paying the loan off and will reduce the amount of time that you will need to make mortgage payments.
An Example of Amortization in Action and what it can Cost Consumers
Jack and Jill are two consumers who found out about amortization the hard way.
Jill and Jack found their dream house but it cost $165,000 so they needed a mortgage. Jack and Jill went to Mr. Wolfe’s mortgage company where Mr. Wolfe offered them a no-money down mortgage with 7% interest for 20 years.
This deal sounded great to Jack and Jill until they opened their first mortgage payment bill. Then they were shocked to see that they would be paying $1,279.24 a month on their mortgage for the next 20 years. Had Jack and Jill bothered to use an amortization calculator they wouldn’t have been surprised. They would have seen the cost of the payments and refused to sign Mr. Wolfe’s mortgage.
The calculator would have also told Jack and Jill that if they had taken out a 30-year mortgage with the same rate of interest they would have been paying $1,097.95 a month. They might have also learned that if they had shopped around and found a 3% interest rate their monthly payment would be just $695.65 or a little more than half of what they ended up paying to Mr. Wolfe.
Amortization can actually save homebuyers and others money. Learning how to use an amortization calculator is the smartest move that a homebuyer or homeowner can make.