Mortgage loan amortization is the gradual reduction of the loan principal through periodic payments.
Notice that amortization refers to the re-payment of the loan principal that is owed. Mortgages are loans the are secured by property that is used as collateral or security for the loan. As any other loan, their main characteristics are the duration and the
mortgage rate.
Mortgages can be distinguished in three categories in terms of amortization:
1. Interest-only mortgages with no payments of principal (no mortgage loan amortization)
2. Loans with partial amortization (balloon mortgages)
3. Loans with full-amortization (otherwise referred to as self-liquidating loans)
Mortgages are typically used for the financing or refinancing of property acquisitions for two main reasons. First, because the purchase of real estae is capital intensive, that is, it requires a large amount of capital and, second, because under certain conditions, the use of borrowed funds can greatly enhance investor returns.
Interest-Only Loans
Interest-only loans also referred to as term loans, call for payment of interest only and no principal. In this sense, there is no mortgage loan amortization and the entire loan amount is due upon the expiration of the loan. The advantages for the borrower of this type of loan is that it minimizes the annual mortgage payment and that the whole debt service is tax deductible,since it is only interest, at least in the US and many other countries that have similar provisions in their tax code.
Partially-Amortizing Loans
Partially-amortizing loans (or balloon mortgages as otherwise referred to) as the term implies, call for partial repayment of the principal over the term of the loan with the remaining balance due upon expiration of the term of the loan. Usually the amount of principal due upon maturity of the loan is significant. The reason for the significant outstanding balance at the end of the term of the loan is because the loan amount is amortized over a significantly longer period than the actual term of the loan. For example, a balloon mortgage with a term of 10-years may be amortized over 20 or 30 years. In other words, the annual loan payment is determined as if the full principal of the loan will be repaid in 20 or 30 years and not 10 years, which represent the actual term of the balloon mortgage. In this way, the borrower by the end of the 10 years will repay only a part of the principal, and the significant remaining balance will be due as the balloon payment at that point in time.
Fully Amortizing Loans
Fully amortizing loans, or self-liquidating loans as otherwise referred to, are loans that call for full repayment of the loan principal by the time the loan term expires. This is the type of mortgage financing or refinancing that is most commonly used for residential mortgages in the United States, the UK and most countries. Depending on whether the mortgage is fixed-rate or
adjustable-rate the monthly/annual loan payments may be constant or variable. Notice that only a part of that payment goes for repayment of the principal while the remaining part for full payment of interest owed. Notice also that as the principal owed is reduced gradually and the interest owed is decreasing, a larger amount of the payment will go towards repayment of the loan principal.
Mortgage Loan Amortization Examples
Let’s see how the acquisition of a residential property valued by the bank at $500,000 can be financed under the different mortgage loan amortization regimes described above. It is noted that the examples provided below may not be necessarily realistic under current market conditions or lending practices; they are only provided for demonstration purposes.
Basic Assumptions
Lender’s maximum allowable loan-to-value (LTV) ratio: 70%
Loan amount: 0.70 x 500,000 = $350,000
Investor’s equity: $150,000
Let us consider first the case of a hypothetical interest-only financing (no mortgage loan amortization) with the following terms:
Term of the loan: 5 years
Interest rate: 7%
Full principal due at the expiration of the term of the loan: $350,000
Interest-only annual payment: 350,000 x 0.07 = $24,500
Balance due at the end of the term of the loan: $350,000
Now let us consider the case of a hypothetical partially amortized loan (balloon mortgage) with the following terms:
Term of the loan: 10 years
Fixed interest rate: 6.5%
Term used for mortgage loan amortization: 30 years
Annual loan payment: $26,802.10
Balance due at the end of the term of the loan: $295,319.19
Finally, let us consider the case of a fully-amortized loan for the purchase of this property:
Term of the loan: 30 years
Fixed interest rate: 6.0%
Annual loan payment (both interest and principal): 25,427.12
Principal due at the expiration of the term of the loan: $0
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