Amortization refers to the process of spreading out a loan into a series of fixed payments over time. When it comes to real estate, this typically means a mortgage loan on a property. The payments are divided into two parts: the principal, which is the original amount borrowed, and the interest, which is the charge for borrowing the money. Over the term of the loan, the balance of the principal decreases through each payment, and the loan is eventually paid off in full, which also transfers full ownership of the property from the lender to the borrower.
The amortization schedule, which outlines each payment throughout the life of the loan, is a key tool for investors to understand how much of each payment goes toward the principal versus interest. This schedule helps in assessing the long-term financial impact of the loan, planning for cash flows, and determining the potential return on investment for a property. Additionally, in real estate investments, understanding amortization is crucial for strategic decision-making, such as refinancing opportunities, property holding periods, and tax implications.
For example, a $100,000 mortgage with a 5.0% interest rate and a 30-year amortization schedule would consist of monthly payments of $536.82. The month one payment would allocate $416.67 to interest ($100,000 balance multiplied by the 5.0% interest rate divided by 12 months) and the balance of $120.15 would be applied toward principal reduction.
In month two, the principal balance would be reduced to $99,879.85 ($100,000 beginning balance less the $120.15 principal payment from month one) and the monthly payment would be allocated $416.17 to interest ($99,879.85 balance multiplied by the 5.0% interest rate divided by 12 months) and the balance of $120.65 applied toward principal reduction.