Source: Cirios Trends,Volume 1, Issue 2
March 2, 2009;
By the Numbers: Amortize This
When you go to get a loan and the banker starts yammering on about amortization schedules, listen.
While amortization choices have shrunk in the last few years as exotic lending has all but disappeared, there are still important decisions to be made on this front.
Amortization is the process by which you pay back your loan through regular payments. Most 30-year, fixed rate mortgages are fully amortized, meaning that on Day 1, your loan payment is calculated and stays the same for the life of the loan.
The formula to calculate this monthly payment is simple: Ok, maybe its not so simple, but the point is that there’s a standard way of calculating your payment that depends on only 3 variables:
A = Your monthly payment P = The principle amount (the amount you borrowed) n = The number of periods on your loan (for most loans, a period is a month), and r = Your interest rate (per period, expressed as a decimal).
For example, a $400,000 loan at 6.0% amortized over 30 years would work out to a monthly payment of $2,398.20. If you pay this amount every month for 360 months, you’re free and clear, having paid all interest and principle due the bank.
Over the life of our example loan, the portion of your payment that goes towards interest versus principle varies over time. In your first payment, $2,000 (83%) goes towards interest. At ten years, that drops to 70%. Twenty years, 45%. Your last payment is 99.5% principle.
An interesting consequence of this aspect of mortgages is that by making larger payments up front, you can make a huge difference to your personal bottom line.
If you tack on an extra $200 to each of your first 12 payments, every dollar goes towards reducing your principle balance. After 30 years, you save $13,000 in interest costs and finish paying the loan off 6 months early.
Perhaps more importantly (since not everyone holds onto their mortgage the entire 30 years), the day you pay down that extra $200 in principal, you begin to reduce your interest expense. It’s like putting money into a savings account earning 6.0%.
On top of that, each extra payment you make reduces the amount you owe the following month: So as long as you continue to make payments regularly, you’re ahead of schedule. In our $200-a-month example you are $2400, or one full payment ahead after just 1 year.
If down the road you have some unforeseen expenses and need to skip a payment, no problem, you won’t be considered delinquent.
And the kicker: Because your principle balance was reduced for the entire time you were ahead, more of your payments went towards principle each month, further reducing your principle balance. In our example, if you skipped a payment at the beginning of year five, you would still owe $750 less in principal then you would if you hadn’t gotten ahead of the curve.