Amortization

In simple terms, Loan Amortization is the portion of your monthly payment that is applied to your principal balance. When you make mortgage payments, some of the money goes to principal and some goes to interest. Because interest is calculated as a percentage of the principal owed, the amount of amortization changes over the life of the loan. Calculating the amortization of your loan over time requires the use of an amortization schedule spreadsheet or an amortization calculator.

With a fixed-rate mortgage, the amortization schedule can be easily calculated from the outset, since the interest rate never changes. Fixed-rate amortization is very simple and predictable: Each month, a larger portion of your payment goes to principal and a smaller portion towards interest until the last payment when the obligation is satisfied and there is no more to pay on either.

With any kind of adjustable-rate mortgage, amortization is more difficult to determine. When the interest rate on an ARM remains constant, it behaves the same as a fixed rate. But when the interest rate changes (and it will), the schedule must be adjusted. One of the pitfalls of ARMs is that you can potentially get into negative amortization.

Negative Amortization

If the interest charges on your loan exceed your payment in any given month, your amortization is said to be negative. This can happen if your monthly payment is capped at a certain amount but your interest is allowed to fluctuate. Usually, the unpaid interest is added to the principal, compounding the problem. Because of this, negative amortization should be avoided at all costs - make sure you understand the terms of your loan before signing to ensure that you won't get caught in this trap.