What is Principal, Interest, Term and Amortization

While these factors are basic to a mortgage loan, it is equally true that the principal amount, interest rate, term and modernization is common to all kind of loans. It does not matter what you are buying from the money that you borrow, these terms will apply and will hold you in good stead if you understand them. Let us speak about them one by one.

Principal

The principal of the loan is the amount that you have originally borrowed. If you borrowed $200,000 to purchase a home, then $200,000 is the principal amount.

Interest

Interest is what the mortgage lender or any other kind of credit lender earns on the principal amount that you borrow. Taking the previous example of a mortgage of $200,000 from a lender, the lender will charge a certain rate of interest on this amount. This is what he will earn on the money he has lent you. The interest rate on different loans differ. While a mortgage loan usually has the lowest of interest other kind of loans such as credit cards may have interest rate as high as 24%.

Consumer interest for outstanding balances such as credit card debt and a car loan is not deductible on your federal income. Interest paid on a home loan can be used as deductions from your state and federal income tax. This is one of the many advantages of taking a mortgage loan.

Term

The ‘Term’ of the loan is the duration in which you are supposed to pay back the principal plus interest to the lender. This is the time given to you by the creditor to repay the money that you have borrowed. Smaller loans usually have a smaller term whereas larger loans have a longer term. You typically get more time to pay back larger loans in order to keep the monthly payments low. For example you would spend $734 a month to repay $100,000 loan with an 8 percent interest rate on the 30 year mortgage term. The same mortgage would cost you $956 a month with a 15 year term. Even though the 15 year loans payment is $222 higher you’d pay far less interest on it over the life of the loan.

At 8% you are paying $72,080 in interest over 15 years whereas for 30 years you’ll be paying $164,240 as interest. Don’t get fooled by a low monthly payment for long-term mortgage. It will be more costly in the long run as compared to a mortgage with a shorter term. The reason why people choose a longer term over a shorter term is to reduce the monthly payments and to make it the size that they can afford to pay comfortably every month. Apart from that, the quicker that you can pay off the loan the more money you save.

Amortization

The fully amortized monthly payment means that if all other factors remain same such as the interest rate and the term, your loan will be fully repaid by the time you’ve made your final loan payment according to the term of the mortgage.

Typically speaking, each monthly mortgage payment that you make fully amortizes what you owe on the loan. Amortization means making periodic installment payments on a loan amount which consist of principal and interest.

Usually the amortization schedule of your mortgage or any other kind of loan is worked out in such a way by the lender that during the initial years of the loan, the installment payment goes mostly towards paying off the interest and very little towards reducing the principal balance owed on the loan. This ratio decreases with time. So in other words, the lender makes sure that he takes his profit on the loan from you as quickly as possible.

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