Amortization itself is a broad term that refers to any instance where the principal balance of a debt is paid down by installments that adhere to a schedule.
This schedule can based on simple interest such as credit cards, but it would have to anticipate payments above the simple interest minimum amount. Thus even credit cards or an interest only loan can have amortization, but they are not amortized of their own accord.
True amortization means there is a forced schedule in place to eliminate the debt. The word is based on the Latin root “mors,” which means “to die.” Thus amortization is a schedule put into place at the beginning of repayment that will “kill” the debt.
This brings us to Mortgage Amortization. Most fixed rate mortgages that have an interest rate greater than zero have the same AMORTIZATION SCHEDULE. This is simply a schedule that determines what portion of what payments will be allocated toward interest and what portion will be allocated toward principal. As you may be aware, the beginning payments in a mortgage are allocated much more heavily toward interest. In other words, the first payment is almost all interest whereas the last payment is almost all principal. This change takes place gradually throughout the life of the loan as is know as “front loaded interest,” and is synonymous with mortgage amortization.
Compare this to level amortization where each payment has the same amount of principal and interest and you can quickly see that mortgage amortization was created to favor banks. This is a tool used by banks to protect themselves against loss. If they collect as much interest as possible up front, they can account for the potential loss that occurs when someone defaults.
It may not seem fair, but that’s the way it is. This is the equation:
Where P = principal, R= interest rate divided by 12, N=number of payments, A = payment.
All technical definitions aside, a mortgage with amortization means that a mortgage will pay off the debt if you keep making payments according to a schedule. So there are interest only loans (no amortization) and fully amortizing loans, such as a 30 year fixed non-interest-only, which will pay off in 30 years if you keep making the same payment.
Keep in mind that there are FIXED loans that are also INTEREST ONLY. In this case, what you usually get is a 10-15 year interest only loan followed by a 15-20 year fixed, amortized loan. Your payment will go up quite a bit when your interest only period runs out EVEN IF the interest rate is fixed. The reason? You went from interest only to amortizing. Now, instead of just paying interest, you also have to pay enough of the principal each month to pay the house of in the remaining 15-20 years.
Also watch out for 2-10 year fixed loans. These are essentially ARMS (adjustable rate mortgages) that have a fixed interest rate for the introductory period. If you happen to still have the loan by the time that period expires, your loan will then be “re-amortized” based on the new adjustable interest rate in order to “kill the debt” by the time the loan is done. If the interest rate is higher than when you got the loan, or if you introductory rate was set lower than the actual interest rate, your payments would also go up in this case, even your loan WAS NOT interest only.
The industry gives preference in terms of pricing and qualifications to fully amortizing loans. The main reason for this is that they get to hold on to more of your money. The secondary reason is that it is slightly less risky if you are actually making some headway on principal each month.
Hopefully this answers a very complicated and confusing question. If you need additional clarification please let me know and I will update this answer.
If you’d like to begin learning more about methods to beat the banks at their own game and actually BEAT amortization, you might consider educating yourself on the principals behind Mortgage Acceleration. See the answer on mortgage acceleration here.