When you borrow money to finance a home, you eventually have to pay that money back. The term amortization is an old English word that means "kill," and in a loan context it is used to describe the process of erasing or killing off a debt. However, while all mortgages need to be repaid, some loans do not actually amortize.
An amortized home loan is completely paid at the end of the loan's term when a borrower makes regular payments that include principal and interest over the life of the loan. A non-amortized home loan requires the payment of the total principal amount in a lump sum instead of through regular installment payments.
How Amortization Works
An amortizing mortgage is a fixed-term loan on which you make a series of roughly equal payments. Your lender arranges the payments so that the entire loan is paid off at the end of the mortgage term. A portion of each payment goes towards both the principal and the interest. Initially, the bulk of your payment goes towards the interest, but as you near the end of the loan term, most or all of your payment goes towards the principal.
Late payments disrupt the amortization process. You can get back on track by making additional principal payments or you can extend the loan term.
Non-Amortization Home Loans
On a non-amortization loan, your payments are not structured to pay the debt off by the end of the loan term. However, non-amortization loans do have a maturity date, which means you may have to make a lump sum principal payment when the mortgage reaches maturity. As with an amortizing loan, you typically make payments on a monthly basis. In many instances, you make interest-only payments in which case your principal remains the same.
Types of Non-Amortizing Mortgages
Home equity lines of credit are non-amortizing mortgages. When you set up a HELOC, you gain access to a credit line that you can draw on and pay off at any time. A HELOC works similarly to a credit card, although it has an expiration date after which you can no longer use it. The nature of the product means it cannot amortize. Your lender may convert the HELOC into an amortizing loan if any balance remains at the end of the contract term.
The amortization process on an adjustable rate mortgage changes every time the rate resets. Some of these loans also begin with an interest-only period that makes amortization impossible.
Amortizing Vs. Non-Amortizing Payments
With an amortizing loan, you know precisely how much you have to pay and when your loan term ends. With a non-amortizing loan, you have the flexibility to make small monthly payments for much of the loan term. These loans appeal to house-flippers who want to keep costs to a minimum as they buy and sell homes. Non-amortizing loans also appeal to people with low incomes who cannot presently afford the payments on an amortizing loan.
However, falling home prices can quickly erase the equity you have built up in your home. The risk is greater with non-amortizing loans because your home's value may fall while the principal on your loan remains unchanged.
- Jupiterimages/Photos.com/Getty Images