Amortization Made Simple
Are you familiar with the Rule of 72s? That’s what the financial industry calls the formula used to calculate how much you owe on your loan each month for the life of your loan. It’s a complicated formula, as each month you pay down a certain amount of principal and a certain amount of interest, so for the following month, the remaining loan amount is different. Each month, the amount of principal owed and the amount of time the balance will be outstanding change, which affects the amount of remaining interest, which affects the amount of principal that can be paid in that one payment, considering that the monthly payment has to stay the same every month for the life of the loan. Also figured into this equation is that the lender wants a much larger share of his interest paid to him before you ever get around to applying the payment to what you owe.
Work Through an Amortization Example
Here’s an example of the Rule of 72s:
You borrow $250,000 at 6.5% APR for 30 years in a standard mortgage.
Your monthly mortgage payment (principal and interest) calculates as $1,580.17. If you made your payment every month for the life of the loan and paid the loan off, here’s what you would have paid back:
Total principal paid $250,000.00
Total interest paid $318,861.20
Total repaid (principal plus interest) $568,861.20
The actual interest percentage on the principal 127.544%
Wait, you borrow $250,000 and you have to pay back more than a half a million dollars. Sound like something from gangster movie? No, it’s just the Rule of 72s, and it’s legal. Really.
Now, I know you think it couldn’t get any worse than that, but here goes: The Rule of 72s is designed so that the lender gets most of his interest paid back up front. So if you pay off the loan before the 30 years are up or even in the first few years, the lender gets nearly all his interest on the loan, and you still owe the majority of what you borrowed. That’s what is called amortization.
In the United States today, the average homeowner sells his or her home every seven years. That means the average 30-year mortgage is paid off early, every seven years after payment #84 and a new mortgage is started. Using the same scenario, at the end of seven years when you ask your lender for a payoff, you’ll be told that by making monthly payments of $1,580.17 each month for seven years, you have paid in $132,734.97.
What do you still owe on the $250,000? $226,040.65! That’s right. You’ve paid down only $23,959.35 in seven years after paying a total of $132,734.28. Of that total, $108,774.93 went to pay back the lender’s interest, and only $23,959.35 went toward the $250,000 you borrowed.
Take a look at this: The first mortgage payment you make breaks down like this:
Total payment $1,580.17
Does that breakdown make you want to break down? Don’t get upset about it. Everyone who owns a mortgage has the same deal. Most just don’t know it or don’t want to.
Today, fewer people actually want to pay off a 30-year conventional loan. The average U.S. homeowner today buys and sells his or her home every seven years. As a result, there’s a huge trend today toward interest-only loans. With these loans, you pay only the interest and none of the principal. This arrangement keeps your monthly mortgage payment as low as possible, increasing the amount you can afford each month. Most people figure that the incredible appreciation real estate has been realizing over the past few years will more than compensate for the interest paid, and 100% of the loan payments are tax deductible.