Buying a house is exciting. Most people get mortgage to purchase a house. For most people buying a house is the most expensive purchase in their lives. Most people don’t understand what amortization is. This begs to ask the question “If the biggest factor of the biggest expense is not understood, how can you reduce that expense?”
If you play a board game you need to know the rules to be able to play and you need to know what is required to win before you can develop a strategy. When purchasing a home via financing wouldn’t it be in the in your best interest to understand the rules and apply it towards your goal.
The word amortize just means periodic. So when you talk about a amortized loan you talk about a loan that has equal periodic payments. (A lump sum is spread out into equal payments. The size of the payments is determined by the time of the life of the loan.) At a zero percent interest the principal is just divided by the periodic payments over the length of the loan. The example below is a $100,000.00 loan with yearly payments over six years and over three years. Payment=Principal/Time is the basic formula. Time and payment are the inverse of each other. If you want to pay off the loan earlier you have to make bigger payments. If you want to have smaller payments you have to increase the time.
Amortization and Interest
Most loans incorporate interest as a form of profit for the mortgage lender. (The following is a basic concept of how a payment is determined; the math is a little more complex and beyond the scope of the article.)
In a monthly scheduled payment loan this is determined by the loan principal times the interest rate divided by 12. This is the monthly interest payment. The remainder of the payment is put towards the principal. (an interest only loan would just be the interest and no principal; you are then doing a lease from the mortgage company.)
Interest = Principal X (Interest Rate / 12)
Payment = (Interest + Principal Payment)
Interest is determined by the total principal so the lower the total principal is the lower the interest would be. It is a direct relation as below:
When the payments are amortized to equal periodic payments the first payments are weighed towards the maximum interest payments because the loan is at the maximum principal amount. Most mortgages are 30 year mortgages so with this context lets look at a amortization schedule’s first payment to compared with the last payment. ( $100,000 loan at 5.25% for 30 years )
The payments are equal throughout the loan but the breakdown is different from the first payment to the last.
On the first payment the interest is 3.8 times the size of the principal payment. On the last payment the principal is 275 times the interest. So it only makes sense if you are going to pay more towards the principal it is more cost effective to pay earlier than later. (Time really is money here!)
Here is a look at the first year’s breakdown on the amortization schedule.
The real cost for the first year is $5,215 for the loan. This is a effective interest rate of 370% . (I don’t know any stock market investment I could realize that kind of return.) What if you were to make one extra principal payment per month?
Extra Principal Payments
The ability to pay an extra principal payment per month is easier in the beginning as the payment increases as you go. The total extra principal payments made was $1,450 which saved $5,176 in interest payments.
This tactic had the added benefit of decreasing the loan term by one year. Until the whole loan is payed off there is a risk of foreclosure. The risk of foreclosure has been decreased by one year.
The above example is just an example of one extra principal payment per month. This was just an illustration to show the effect on extra payments on the bottom line. This concept can be applied more aggressively. Two or more principal payments per month increases the savings and decreases the time under the thumb of the lender.
The more of the real estate that is owned by you rather than the lender puts your position of power. The bigger piece of the real estate pie you own for the property the less of a risk you have if the value of the real estate decreases.
Suppose there is a downturn in the economy where you live. You lose your job and the value of your house has decreased. If you have paid extra towards the principal of the house you are at less of a risk of being up side down. If there is a job outside your local area and you are up side down you have made a move more difficult or impossible.
There are other ways to exploit the amortization schedule financial structure.
- Bi-weekly or weekly payments are a way to accelerate the payment of the principal. This in turn decreases the interest paid.
- Taking lump sums and applying towards principal.
- Applying small periodic gains. Get a raise, save on cable, get a side job, etc and apply the gain towards the principal and increase the value of that gain.
Short Term Loan Shifting
This is the idea that if you could take a short term loan and pay the mortgage principal down. This works with only with positive cash flow (spending less then you make) The main gain is the realized cost of the short term loan is less than the cost of the amortized interest. There are better people at explaining this than me but, using an equity line of credit is the vehicle to make this happen.
See: TruthinEquity.com for this method explained.
The bottom line this is a time is money equation. An amortization schedule understanding can help you save both time and money.