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Amortization Primer : Slow Painful Death of a Loan or Welcome Relief ?

By
Industry Observer TN LIC# 290452

                                         amortize

The word "amortize" means "to kill off slowly over time".

To "liquidate gradually".

Almost all deed of trust and mortgage loans are amortized loans.

These are loans that are paid off slowly in equal payments over time in equal and regular periodic payments usually made over a term of years.

Usually, these periods are either 15 or 30 years although other arrangements are available for mortgages.

These regular, periodic payments partially pay off both the principal and interest portions of the loan.

In each payment, part is applied first to the interest that's owed on the loan, and the balance of the payment is applied to the principal remaining balance. 

When the loan reaches the end of it's term the entire amount of the principal loan amount and all of the interest is reduced to a zero balance. 

We also can refer to these type of loans as direct reduction loans.

The most frequently used type of loan is the fully amortized loan.

This mortgage has a constant amount which is paid usually on a monthly basis and the lender will credit each payment first to the interest and second to the principal amount of the loan.

In theory, each payment should remain the same throughout the life of the loan. While the amount applied to the principal grows the amount of the interest due will decrease because the unpaid balance of the mortgage is declining.

Paying additional amounts towards the principal balance will kill the loan a little faster which can be a good thing.

The borrower can save some interest if the loan is paid off before the end of the term.

But, we also know, lenders can take preventive measures against an early payoff to prevent the loan from not making money for them and include some stiff penalties for paying the loan off early.

These penalties are referred to as prepayment penalties.

The penalty could amount to a percent of the entire original principal balance.

Let's say for example, you took out a 200 thousand dollar loan, paid down 100 thousand and then paid the balance off in a lump sum after you had made 100 thousands dollars in payments, and you had a prepayment penalty of 5% interest on the original principal loan balance, you'd now owe the lender an additional 10 thousand dollars.

The lender might even require all of the interest due from the first ten years of the loan as a prepayment penalty.

Remember though, lenders may not charge prepayment penalties om mortgage loans guaranteed or insured by the federal government or on loans that have been sold to Freddie Mac (The Federal Home Loan Mortgage Corporation) or Fannie Mae (The Federal National Mortgage Association).

What experiences have you had with amortized loans and what do you see in place for today's borrowers?

Have I left anything out that you'd like to add?

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Comments (2)

Vanessa Krempa
Princeton, NJ

Prepayments are good if it helps a person to sleep at night and they plan to stay in the home for a long period of time. I think your post may scare people with the long explanation of prepayment penalties, but so many people won't have that experience.

May 10, 2008 10:27 PM
David Saks
Memphis, TN
Broker / Industry Analyst

Agreed, Vanessa. Federal loan guarantee programs should help eliminate the need for Sominex.

May 11, 2008 04:27 AM