What is 'Accelerated Amortization'
Accelerated Amortization is a process by which a mortgagor makes extra payments towards mortgage principal. With accelerated amortization, the loan borrower is allowed to add additional payments to their mortgage bill in order to pay off a mortgage before the loan settlement date. The benefit of doing so is reduced overall interest payments.
BREAKING DOWN 'Accelerated Amortization'
Here's an example of Accelerated Amortization. Let’s say there’s a mortgage originated for $200,000 at 7% interest for 30 years. The monthly principal and interest payment is $1330.60. Increasing the payment by $100 per month will result in a loan payoff period of 24 years instead of the original 30 years, saving the borrower six years of interest. Paying a mortgage in an accelerated manner decreases the loan premium faster and diminishes the amount of additional interest the borrower needs to pay on the loan. A borrower can also accelerate the amortization of his loan by making more than one payment per month. The extra payment goes directly toward paying down the principal loan.
Accelerated Amortization in the United States
Mortgage borrowers in the United States typically take out a 30-year, fixed-rate loan, secured by the property itself. The length of the loan, and the fact that the interest rate is not variable, means that borrowers in the United States typically pay a higher interest rate on their loans than borrowers in other countries, like Canada, where the interest rate on a mortgage is typically reset every five years. This higher interest rate may encourage borrowers to use accelerated amortization strategies in order to pay down their loan more quickly to decrease the total interest payments.
But there are many other reasons why it might not make sense to pay down a mortgage loan early. The most important reason is that interest on the first $750,000 dollars in mortgage debt is tax deductible according to the U.S. tax code. By paying down a mortgage early, homeowners would increase the income tax they owe, all else equal. In such a scenario, it may make sense for homeowners to use the funds they would have used for accelerated amortization to invest in a retirement or college fund. Such a fund would earn a return, while maintaining the tax advantage of a mortgage-interest deduction. Very affluent buyers, however, who already have sufficient retirement funds and sufficient capital to make other investments, may want to pay down their mortgages early.