When considering a mortgage, one of the most important factors to understand is the amortization schedule. This is the schedule of principal and interest payments over the life of the loan. But why is the amortization schedule the way it is? Why can’t banks split it proportionally so that all 360 payments (in the case of a regular mortgage) have the same principal and interest payment?
The answer lies in the way interest is calculated. Interest is a percentage of the remaining balance on the loan. In simple terms, this means that you pay more interest when the balance of the loan is higher, and less interest when the balance is lower.
For example, say you borrow $240,000 at 10% interest. The first month’s interest will be about $2,000 ($240,000 * .10/12). So if your principal and interest payment is $2,500, you’ll pay $500 principal that month. Some years later, you’ll owe $120,000. Then you’ll be paying about $1,000/month in interest and $1,500 of that same $2,500 payment will go towards the principal every month. Years later you’ll owe $12,000 and only $100/month will be interest.
So why can’t banks split principal and interest payments proportionally? The answer is simple: because the math won’t add up. If you wanted to make the same payment over 30 years, the bank would have to take the interest rate and work out what the monthly payment would need to be so each of the 360 monthly payments is the same amount while accounting for the interest owed on the remaining principle.
Of course, if you wanted to, you could always change the percentage split of principal and interest payments by paying extra. For example, if you fully paid off the mortgage in the first payment, it would be almost all principal.
At the end of the day, it all comes down to why you wanted the loan in the first place. If you wanted to borrow money for 30 years, the amortization schedule is the best way to ensure that each monthly payment is the same.