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6/27/2018 Mortgage Amortization: How Does it Work?

- The Mortgage Professor


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Mortgage Amortization: How Does it Work? 1/4
6/27/2018 Mortgage Amortization: How Does it Work? - The Mortgage Professor

(c) Can Stock Photo / designer491

August 18, 2000, Revised August 4, 2004, December 1, 2006, July 9, 2007, Reviewed July 21, 2009, August 27,

"After reading several of your articles on paying off mortgages early, I came to the conclusion that I really didn't
understand the basic rules of mortgage accounting. Can you explain them in a simple way?"

I'll try. While mortgage amortization accounting is not the easiest thing in the world to understand, it isn't rocket
science either. Since borrowers are stuck with their mortgages for years, it is a good idea to know how the
accounting works.

Amortization Accounting
Except for Simple Interest Mortgages, the accounting for amortized home loans assumes that there are only 12
days in a year, consisting of the first day of each month. Your account begins on the first day of the month
following the day your loan closes. You pay "interim interest" for the period between the closing day and the day
your record begins. Your first monthly payment is due on the first day of the month after that.

For example, if your 6% 30-year $100,000 loan closes on March 15, you pay interest at closing for the period
March 15-April 1, and your first payment of $599.56 is due May 1. That payment includes the interest due for
April. The interest payment is calculated by multiplying 1/12 of the interest rate times the loan balance in the
previous month. 1/12 of .06 is .005. The interest for April due May 1, therefore, is .005 times $100,000 or $500.
The remaining $99.56 is principal, and reduces the balance to $99,900.44.

The principal payment is always a residual, the difference between the total payment and the interest due.

The process repeats each month, but the portion of the payment allocated to interest gradually declines while the
portion allocated to principal gradually rises. On June 1, the interest due is .005 times $99,900.44, or $499.51. The 2/4
6/27/2018 Mortgage Amortization: How Does it Work? - The Mortgage Professor

amount available for principal rises to $100.06.

While the payment is due on the first day of each month, lenders allow borrowers a "grace period", which is
usually 15 days. A payment received on the 15th is treated in exactly the same way as a payment received on the
1st. A payment received after the 15th, however, is assessed a late charge equal to 4 or 5% of the payment.

Extra Principal Payments

When borrowers elect to increase the amount of their payment, the principal payment increases by the same
amount, so the balance is reduced by that amount. For example, if the borrower paid $699.56 on May 1, the
balance would drop by an additional $100 to $99,700.38, which in turn would reduce the interest due June 1 to

Extra payments that are made later in the month might have the same effect, or might not be credited until the
following month, depending on the lender. To be credited within the same month, extra payments have to be
received before the Nth day of the month, but N varies from one lender to another.

These rules are advantageous to many, perhaps most borrowers because of the backdating of payments to the first
day of the month. Thus, the borrower who pays $599.56 on May 15 has the use of $599.56 free of interest for 15
days. The same is true of extra payments received before the Nth day of the month.

Mortgage Amortization Tools

Readers are encouraged to develop an actual amortization schedule which will allow them to see exactly how the
numbers change. They can do that using one of my calculators. For straight amortization without extra payments,
use my calculator 8a, Amortization Schedule Including Tax Savings. To see how amortization is impacted by extra
payments, use 2a, Mortgage Payoff Calculator: Extra Monthly Payments.

If you want to experiment with different payments and/or maintain a permanent record of your loan, download one
of my spreadsheets, Extra Payments on Monthly Payment Fixed-Rate Mortgages or Extra Payments on ARMs.
Unlike the calculators which can't be moved from where they are, the spreadsheets can be transferred to the hard
drive of your computer.

Payment Rigidity
A major problem with the existing mortgage is the absolute rigidity of the payment requirement. Skip a single
payment and you accumulate late charges until you make it up. If you skip May, for example, you make it up with
2 payments in June plus one late charge, and you record a 30-day delinquency report in your credit file. If you
can’t make it up until July, the price is 3 payments plus 2 late charges plus a 60-day delinquency report in your
credit file. Falling behind can be a slippery slope into foreclosure.

Payment rigidity also prevents many borrowers from organizing their personal finances in the best way. Some
examples from my mailbox:

*Borrower A wanted to use a bequest to reduce the monthly payment on a fixed-rate mortgage. No way. If A used
the bequest to prepay principal, it would shorten the period to term, not reduce the payment.

*Borrower B wanted to use a bequest to reduce the term on an adjustable rate mortgage. No way. If B used the
bequest to prepay principal, it would reduce the payment, not shorten the term. 3/4
6/27/2018 Mortgage Amortization: How Does it Work? - The Mortgage Professor

*Borrower C wanted to double his payment in December when he receives his bonus and skip a payment in August
when he has no income. No way. If C used the extra payment in December to prepay principal, he still had to make
the payment for August.

*Borrower D is paid twice a month and wanted to make his mortgage payment twice a month. No way. Borrower
D must bank his mid-month payment and pay the lender once a month.
No one instrument will meet everyone’s needs. Many borrowers who actively manage their family finances,
however, are ill-served by the current amortized mortgage.

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