The ABC of amortisation

WHEN you apply for a home loan, you will definitely hear the term “amortisation”. It is important to understand how this works because it holds the key to good management of your mortgage.

“Amortisation is the process of paying off a debt or a loan over a set period by making monthly payments that are each made up of two parts: the principal repayment and the interest repayment,” says Shaun Rademeyer, CEO of BetterLife Home Loans, the biggest mortgage originator in South Africa.

“The principal portion of the monthly total goes towards repaying the original amount you borrowed (the capital), while the interest portion goes towards paying off the interest the bank is charging you in order to lend you the money.”

He explains the interest on amortised loans is charged in arrears, and is totalled up every month-end based on how much of the original loan is outstanding.”For example on a R1 million loan on which the bank is charging 9,25% interest a year, the interest due at the end of the first month would be R7 708 and would make up the interest portion of your monthly instalment.

“However, you are also expected to start paying back the actual loan, so your total instalment would actually be R9 159, with R1 450 of that being the principal portion.”

At the end of month two, both the capital amount outstanding and the interest due would be slightly lower, with the result that the principal portion of your monthly repayment would be slightly higher. Your total monthly instalment remains the same but the ratio of principal to interest in that instalment changes.

This ratio, says Rademeyer, will continue to change according to a set pattern – even if the interest rate goes up or down – to pay off the loan within the agreed period. “The rate at which you gain equity in your home is very slow in the initial years of your mortgage, as most of your money is going towards paying off interest.”

He notes you can save thousands of rands worth of interest by paying an additional amount each month to reduce the total capital outstanding. The effect of this is to reduce the amount of interest due each month and change the principal/interest ratio of your regular instalment that the home loan is paid off much faster. For more information contact your BetterLife home loan consultant today.