What does amortization of a home loan mean?
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UPDATED: Nov 30, 2011
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Amortization, a word derived from Latin that means “to deaden,” simply refers to the process of paying off a loan’s principal with regular payments over a designated amount of time.
There are different forms of amortization, particularly when it comes to mortgage loans. You need to be aware of the three types:
- Fully amortized loans
- Partially amortized loans
- Negatively amortized loans
Fully Amortized Loans
Fully amortized loans refer to mortgages that have a set term. They are structured in such a way that at the end of the set term, the loan will be fully satisfied and the borrower will no longer be in debt.
Fixed rate mortgages are perfect examples of fully amortized loans. In a 30 year fixed rate loan there are 360 equal payments that remain equal for the entire duration of the loan (assuming no refinance is made). By the time you pay that 360th payment, your home loan will be fully paid off.
Partially Amortized Loans
On the other hand, partially amortized loans are those that have a set term, but are not structured to be fully satisfied by the end of that term on monthly payments alone. This is because the monthly payments are too low to pay off the loan in the agreed upon time frame.
An example of partially amortized loans is balloon loans. These are loans that have relatively low monthly payments, but at the end of the loan term, the borrower is responsible for paying the remainder of the loan off in full.
That’s precisely why these loans have that name: the loan payments are small, until the end of the term, when the final payment swells up into a massive balloon.
Negatively Amortized Loans
Negative amortization is a different beast all together, and one most borrowers ought to be deathly afraid of. This form of amortization refers to a loan that is not being “deadened,” but rather is “growing.” Payments are made, but the principal is not reduced at all—in fact, the principal actually increases.
The reason this happens is because negatively amortized loans are offered to borrowers with a teaser rate. Lenders tell borrowers what the real interest rate is, but allows them the option to pay their loan at a reduced rate if the borrower so chooses. As a result, if the borrower makes that minimum payment, he or she is not even paying enough to cover the interest, so the remaining interest gets tacked on to the top of the principal.
There are times when negative amortization is a good thing, but those situations are usually reserved for seasoned investors and those not looking to turn a property into their primary residence.