Home Equity Loan Amortization: How it Works

Home equity loans allow you to tap into your home equity for cash, typically at a lower interest rate than with a personal loan or credit card. You’ll get a lump sum loan that you can use for home improvements, consolidating debt, or even to pay for education expenses.

Payments on a home equity loan are usually fixed over the repayment term, meaning how much you owe won’t change over time. But like a first mortgage, home equity loan amortization means your payments are not equally split between principal and interest. Instead, the ratio gradually changes over time.

Understanding home equity loan repayment terms can help you create a smart payoff strategy for your loan.

What is a home equity loan?

A home equity loan is a way to borrow money based on the equity you’ve built in your home. Also known as a second mortgage, home equity loans tend to come with lower interest rates than other forms of financing because the loan is secured with your home as collateral.

The loan will come as a lump sum of cash that you can use for any purpose. The repayment term will consist of fixed payments, which include both principal and interest. You may also have to pay upfront fees, such as appraisal and title search fees, which can increase the total cost of the loan.

How does a home equity loan work?

A home equity loan is largely based on the value of your home compared to your outstanding mortgage balance. Most lenders typically allow for a maximum 80% loan-to-value (LTV) ratio. That means you can borrow up to 80% of your home’s value, including both your first and second mortgages.

Home equity loans typically come with fixed interest rates and repayment terms ranging from five to 30 years. A fixed interest rate means your monthly payment won’t fluctuate over time.

Once you receive your loan funds, you’ll start making payments right away. If you use the funds to repair or upgrade your home, the interest payments on your home equity loan interest could be tax-deductible.

What is amortization?

Amortization refers to the structure of fixed loan payments. Although the payments remain the same each month, an amortized loan adjusts the amount applied to interest and principal over time.

With mortgage amortization, your early payments are usually front-loaded with higher interest payments. Your lender will provide you with an amortization schedule that shows exactly how each monthly payment is distributed. This schedule ensures that your mortgage is fully paid off by the end of your repayment term.

Because of amortization, your principal balance initially decreases more slowly, as more money goes towards paying interest to the lender. But as you pay down your balance, your interest costs will decrease and more of your monthly payment will go toward paying off the principal.

Are home equity loans amortized?

Yes, home equity loans are amortized similar to a regular mortgage. Lenders create an amortization schedule based on interest rate, loan amount, and repayment terms. In addition to the loan amount, you may opt to roll in some or all of your closing costs. This can add to your balance but makes it easier to take out a loan without tapping into your savings.

Your fixed payments are made monthly. As you get closer to the end of your loan term, your payments will be almost entirely dedicated to paying off your remaining principal.

How do you calculate home equity loan payments?

Even though payments are fixed each month, the structure changes when home equity loan amortization comes into play. Interest is calculated based on each month’s updated balance. So the amount of interest starts higher, then decreases little by little each month.

For example: Say you borrow $15,000 over five years at a 4.00% interest rate. Your monthly payment would be $276.

In the first month, $50 of your payment goes toward interest — the remaining portion goes toward your principal.

The next month, you no longer owe $15,000. Your new balance is $14,774. On your next payment, only $49 goes towards interest. By the end of the 60-month repayment period, only $1 goes towards interest and $275 goes toward paying off the remaining balance.

What are the advantages and disadvantages of amortization?

If you’re thinking about getting a home equity loan, consider the following benefits and drawbacks:

Pros

• Fixed monthly payments: An amortized home equity loan comes with the same payment each month. This makes it easy to budget and plan for this extra expense in your monthly budget.
• Flexible loan use: You can use the funds from a home equity loan for virtually any purpose. While you might be able to deduct your interest payments if you use the money to repair or improve your home, you can also use the funds to cover a large purchase or expensive vacation.
• Low interest rates: Because home equity loans are secured with your house as collateral, this type of financing typically comes with lower interest rates than other options.

Cons

• Equity builds more slowly: Since interest payments are higher at the beginning, your balance remains higher for longer. This also means it takes longer to rebuild the equity you tapped into for the loan.
• Closing costs: Home equity loans have closing costs similar to those for a home mortgage. These costs can total 2% to 5% of your loan amount, and cover expenses such as attorney fees, appraisal fees, and title search fees.
• Risk of foreclosure: Because the loan is secured by your home equity, the lender could foreclose on your property if you stop making payments.

Should you pay off your home equity loan early?

The faster you pay off your home equity loan, the more money you’ll save on overall interest costs. Here are some tips on how to pay off your loan faster.

• Choose a lender that doesn’t charge for prepayment. A prepayment penalty is a fee lenders charge for paying off all or a large portion of your loan early. However, not all lenders charge these fees.
• Designate extra payments for the principal only. If your budget allows, you might want to consider making extra payments between payment due dates. These additional payments may go directly toward paying down your principal.
• Pay off your loan with additional income. Consider using a large income source, like a tax refund or bonus, to pay off your loan in a lump sum.
• Refinance your loan. If interest rates have fallen since taking out your home equity loan, you can save money on interest charges by refinancing to a loan with a lower interest rate.