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Quick Guide: Amoritization

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One of the most important things to think about when buying a new home is how much it’s going to cost. For many people, this means not only looking at the actual price of the home, but also considering the financing options they have.

When thinking about the financing options you have for a home, many people make the mistake of just looking at the interest rate. While it may seem as if the bank just randomly assigns these rates, they are actually based on several factors. Many of these factors, such as the LIBOR, you have no control over. Things such as your credit score you have some control over. But the amortization period is something that you can decide on your own.

What Is Amortization?

Simply put, amortization is the amount of time over which you will pay back the loan. Traditionally, the amortization periods for mortgages were either fifteen years or thirty years. Today, however, it is common to find mortgages that are offered for five, ten, or even fifty years, along with every other number in between. Some loans do not even have a standard amortization period. Instead, they allow you to pay only a portion of the interest owed on the loan.

How Does Amortization Affect My Payment?

As long as all other loan factors are the same, the general rule that most loans follow is that the longer the amortization period, the smaller the payment. For example, a loan that takes thirty years to pay off will have much smaller payments than a loan that takes just five years to pay off.

Of course, because interest keeps compounding every year, a longer amortization schedule will mean that you are paying more in interest. Since this extra interest has to be factored into every payment, the amount of the monthly payment will not decrease in proportion with the extra time added to the loan. In other words, there comes a point where you will only save a few dollars every month in exchange for making extra years’ of payments.

When bankers worked out the amortization schedules for a variety of loan terms, it turned out that the two terms that offered borrowers the best options were at fifteen and thirty years (www.bankrate.com). This is why banks have traditionally offered loans only for these amortization periods.

What Else Can Amortization Affect?

Based on this, many people choose for as long of a payment term as possible. Many people like to have the flexibility of a lower monthly payment, and since most mortgage loans allow you to pay extra every month, there is nothing wrong with paying more towards the principal when you have more money coming in. In order to entice borrowers to take a loan with a shorter amortization schedule, many banks offer a slightly lower interest rate.

The lower interest rate can be a great deal if you are sure you can make the higher monthly payments on the shorter loan. Ask your lender for a statement comparing the interest costs of both loans. Consider if paying a little extra over the life of the loan is worth the added flexibility.

Also keep in mind that as your monthly payment increases, the bank might decide to loan you less money. Typically, people who apply for longer amortized loans do it because they need the bank to grant them a higher principal amount. If the bank feels that you do not have sufficient resources to make the monthly payments, it may decide to lower the amount that you qualify for.

When deciding on the right amortization period for your mortgage, there are a lot of factors to consider. Make sure that you take your time and review all of the offers very carefully before deciding which one is right for you. Look at the minimum payment, interest rate, and the total amount of interest you will pay over the life of the loan.

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