Amortization is one of the most important financial concepts to understand when taking out a loan of any kind. Whether you are buying a car, a home, or refinancing a mortgage, it is imperative that you have at least a basic understanding of the amortization process.

One reason that you need to understand how amortization works is because you may want to utilize the equity that you have established in your home mortgage at some point, to leverage other financial transactions. Some people make the easy mistake of assuming that if they have made a $2,000 monthly payment for 5 years, that they would have accumulated $10,000 in equity, but this is simply not the case.

With mortgage loans, an amortization schedule is set up so that you will pay a greater amount of interest in the beginning of the mortgage than you will towards the end of the life of the loan. Many people are quite amazed at how little equity they are acquiring in the first 5-10 years of their mortgage, unless they have an understanding of the amortization process.

Many people would be surprised to see that up to 85% (or more) of their very first house payment goes towards interest fees only. Approximately 14% of that first mortgage payment goes to the principal on the loan.

This does not include what you must pay on taxes, home insurance, and private mortgage insurance. These fees are frequently included in your monthly payment to the bank as a courtesy from the lender. This way the lender knows that you are paying your taxes and insurance fees and it allows you to only worry about one payment each month instead of four.

As the life of your loan progresses, your lender will begin attributing more of your payment towards the principal and less towards the interest. It could be year 21 on a 30-year loan before the balance shifts. By this, I mean that you will have been paying for 20 years before the amount of your payment that goes to your principal equals or exceeds the amount of the monthly payment that goes towards interest fees. Another way to look at this is if you have a $2,000 monthly mortgage payment, $1,000 will go towards interest fees and the other $1,000 will finally go towards your principal. Again, this does not include the insurance fees and taxes.

By the end of the 30th year of your loan, or your last loan payment, 99.5% of your monthly payment will be going towards the principal with the remainder being paid towards interest. As you can see, while the years progress the amount of your payment that goes to your mortgage principal will slowly increase and the amount of your payment that goes towards the interest fees will slowly decrease.

To see this in full detail, you can ask your lender for a copy of the amortization schedule before signing any paperwork. This way you can determine how long it will be before you start to acquire any real amount of equity in your home. You can also use mortgage calculators that can be found online to calculate an approximate amortization schedule.

The overarching idea behind amortization is that the lender gets paid first, and then you can start paying on your principal. This is done in case you default on the loan. If you pay for a few years on your mortgage and then default, the lender can foreclose on your house and recoup the principal, but not the interest fees. The lenders assume that most people will at least pay the first few years before risking any defaults. By having the interest heavy on the front end of the life of the loan, they are making sure that they earn their profit from the mortgage, ahead of any possible loan defaults.

The more that you learn about financial concepts and how lenders divide up the money that you pay them each month, the better you can estimate how much equity you can build up in your home. This understanding of amortization and other financial terms will help you to make smarter financial decisions when considering equity loans and refinancing options.