When you are looking for a home loan, you might focus on trying to get the mortgage with the lowest interest rate. But home loan works rather differently than say, a personal loan because it is an amortised loan. Put it simply, amortization is the process of paying off a balance over time with regular repayments. Understanding how your home loan is amortised can help you make better decisions on whether to refinance or pay off the remaining balance on your loan.
Now, if you are currently paying off a mortgage loan, you will see that each month, you are paying more or less the same amount. In fact, the payment is made up of 2 parts – 1)interests payments and 2)reducing the loan principal. By breaking down these 2 components, you can have a better idea of exactly how much interest you are paying for your loan.
Amortized loans are designed such that you completely pay off the loan balance over a certain amount of time. At the start of the loan, a bigger amount of your monthly payments will go towards interest expense, which means you do not reduce much on your principal repayments in the first few years.
With amortization, it is easier to explain by presenting the data in an amortization table. Here’s a look at a sample table that shows a 20-year housing loan of $600,000 charging 2% interest with monthly repayments:
From the table above, you can see that the monthly repayments remain the same at $3,035.30 per month, but the payment towards interest started at $1,000 in month 1 and gradually reduces along the payment period. On the other hand, the principal component increases as the months move on.
With the amortization table, we can work out that the borrower will be paying a total interest of $128,472 over 20 years, which works out to be 17.6% of the total sum.
How come? Isn’t the interest at just 2% per annum? Well, that’s because of compounding. Looking at amortization is extremely helpful in giving you greater clarity about the amount of interest you are paying. Most people may be shocked to find that they are paying so much interest, which is why refinancing your home loan is so important.
With an amortization table, it can help you determine if you’d rather go with a lower monthly payment and pay more interest over the entire period, or perhaps choose to pay off your debt early to reduce overall interest payments.
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