Not very exciting stuff, but you need to grasp the concept. Stick with me. Tough it out.
Forget about TEOTWAWKI and concentrate on your financial survival. It’s good to pay attention to all the macroeconomic news out there, but if you don’t already know what I’m going to explain to you, what you are about to read could save you hundreds of thousands of $’s.
Don’t listen to the mortgage people. You gotta run the numbers yourself.
Rates are falling to hysterical lows so many folks may be thinking of refinancing. (If you still gots a job to go to that is.)
If you understand amortization then there is no need to read any further. If you don’t then I’ve tried to put together a primer for you.
First some background. I apologize if this is too elemental for you, but some people may not understand so we need to start at the beginning. Let’s imagine that Billie Borrower borrows $10,000 from Libbie Lender. Libbie is going to want to make some money on the deal so Libbie charges interest. To keep things simple, if Libbie charges 5% interest then you’ll end up paying the original $10,000 back to Libbie, plus an additional $500 in interest. All together you pay Libbie back $10,000 in principal and $500 in interest for a total of $10,500. That $500 is an expense to you, a direct cost for borrowing money.
Principal is the amount you originally borrowed. Borrowers want to pay this back as soon as possible.
Interest is the income that the lender demands for lending you funds. Borrowers want to limit interest as much as possible.
Got that so far? If not then Google principal and interest till you understand the difference then read on.
Imagine you get a loan from a lender and your monthly payment is $1,000. Ever wonder what the bank does with that $1,000? Ever wonder how much of the $1,000 is applied to interest and how much is applied to principal? Lenders want their interest as soon as possible.
The method that banks/lenders use is something called amortization.
The monthly loan payment never changes. it will remain $1,000 for the duration of your loan. What fluctuates is how much of the $1,000 is applied to interest and how much is applied to principal.
Banks got it sewed up tight so what do they want? Lenders want their interest as soon as possible.
To illustrate, let’s say that you get a 30 year loan from a bank and your monthly payment is $1,000. The very first payment may be $999 in interest and $1 in principal. The last payment, number 360 (30 years times 12 months/payments a year = 360), may be $1 in interest and $999 in principal. Why? Because the lender/bank wants their money/interest as soon as possible. Wouldn’t you if you were lending?
I’ve pasted in a table so you can see what I mean. Notice the monthly payment stays the same. Notice that the amount allocated to principal increases and the amount allocated to interest decreases over the life of the loan.
# |
Payment |
Principal |
Interest |
Loan Balance |
1 |
$2,649 |
$983 |
$1,667 |
$99,017 |
2 |
$2,649 |
$999 |
$1,650 |
$98,018 |
3 |
$2,649 |
$1,016 |
$1,634 |
$97,002 |
4 |
$2,649 |
$1,033 |
$1,617 |
$95,970 |
5 |
$2,649 |
$1,050 |
$1,599 |
$94,920 |
6 |
$2,649 |
$1,067 |
$1,582 |
$93,852 |
7 |
$2,649 |
$1,085 |
$1,564 |
$92,767 |
8 |
$2,649 |
$1,103 |
$1,546 |
$91,664 |
9 |
$2,649 |
$1,122 |
$1,528 |
$90,542 |
10 |
$2,649 |
$1,140 |
$1,509 |
$89,402 |
When you are considering refinancing or getting a new loan you can’t just look at the interest rate or your monthly payment. You need to look at total interest paid going forwards. The going forwards is key; that’s why I redded it.
Total interest paid going fowards. That’s what counts.
Now you understand that most of the interest that you pay to a lender you pay early in the life of the loan and as the loan matures you pay down more of your principal and less interest.Why? Lenders want their interest as soon as possible.
How can we put this fact to work for us?
A quick explanation will help to understand. At some point during the life of a loan you “flip” and each of your payments is applied more towards principal and less towards interest. When this happens varies depending on the term(length of loan) and interest rate.
I just ran the numbers for a $100,000 30 year loan (360 payments) at 6%. This loan doesn’t “flip” until payment #222. So for the first 221 payments each payment goes more towards interest than principal. That’s right you are 18 1/2 years into a 30 year mortgage before most of you monthly payments are applied towards principal and not to line the lender’s pocket.
Example – Billie Borrower is now 10 years into his 30 year loan with Libbie Lender. Because so much interest is paid in the early stages of a loan, that although Billie is only 1/3 of the way into his loan, Libbie has already probably received 80% of all the interest she will receive over the entire 30 years. Billie’s current monthly payment may now be going 60% interest and 40% to principal. Remember at the beginning the payment is 99% interest and 1% principal and at the end of the loan it’s reversed to 1% interest and 99% principal. Why? Lenders want their interest as soon as possible.
The crux…….If Billie were to refinance now she would be right back to DAY ONE!!! Now Billie is back to paying 99% interest and 1% principal. Why? The chorus please – Lenders want their interest as soon as possible.
As long as you keep refinancing you are stuck paying interest and never paying down the principal (amount you borrowed).
So how do we analyze whether it makes economic sense to refinance or get a loan? We use something called an amortization schedule (“AS”). A good AS will tell you how much of each payment goes to interest and how much goes to principal.
Rule #1 -as I elucidated above is don’t listen to the mortgage people. Run the numbers yourself.
Rule #2 – you can’t pay attention to what happened in the past. What you care about is how much interest you will be paying going forwards.
So if you have a loan at 6% it may seem like a good idea to refi and move your rate down to 5%, right? Not so fast because if you are already 3, 5 or 10 years into your current loan you may be paying more principal than interest and do you really want to go back to payment #1 where you are paying 99% interest and 1% principal? Of course not.
So the only way to figure it out is to run the numbers. Here is one amortization tool that I found on the Internet, http://www.financialpowertools.com/amortization_calculator/index.html. (There may be better ones, but this one gits r done.) After you click “Calculate” then click on “View Report.” The report will tell you how much each of your payments is allocated to principal and how much to interest.
You’re going to have to run the numbers twice. Run them once with your current loan and then add up how much interest you still will be paying from this day forwards. For example, if you are five years into a 15 year mortgage all you want to add up is how much interest still needs to be paid, i.e. add up the total interest for all payments for the final ten years of the loan. This is the toughest part because it’s tedious. Once again, if there are total of 60 payments on a loan and you are 23 payments into it, all you would want to add the interest for are payments 24 through 60. What already took place Mr. Fancy Pants would call, “sunk costs.” They don’t matter so much when you analyze things going forwards because it’s cash taht already flowed under the bridge.
So you got that? You have to figure out the total interest that you still will be paying over the remaining life of your current loan. We can call this “Total Interest Remaining.” Write the number down.
Now run the numbers using the AS that I linked to using the new loan that you are considering. After you click “Calculate” you can just look at the open window where it says, “Total Interest.”
Finally compare Total Interest Remaining (interest still left to be paid on your current loan) to Total Interest (total interest to be paid on your new loan).
If the Total Interest on your new loan is more than the Total Interest Remaining on your current loan you may want to think twice about getting the new loan.
Of course there are all kinds of other reasons to get a new loan, but at least now you are equipped to make an intelligent decision because you can compare the Total Interest Remaining to be paid on your current loan with the Total Interest that you would pay under the new loan you are considering.
I know this is confusing. If you have questions, post a comment or email me.
Just an old chimeny of a cabin since disappeared. About 10-15 years ago we were skiing during a real bad storm and we had to seek shelter in the cabin that stood here at that time. It was good to get out of the elements for a little while, warm up, have a nibble of cheese, meat, fruit or chocolate and take a shot or two of the schnapps that we had.
December 24, 2008 at 5:44 pm
[…] Amortization « Abraham’s Blog Not very exciting stuff, but you need to grasp the concept. Stick with me. Tough it out. […]
January 4, 2009 at 7:44 pm
Appreciate the help! Love the site!
January 7, 2009 at 1:33 am
Thanks for the article – very illuminating. One thing you don’t mention, though, is the idea of accelerating the payments on your refinanced loan (paying more than the minimum, thus paying down the principal more rapidly). If one refinanced a loan with 20 years left on it with a new 30 year loan at a lower interest rate, but had the discipline to keep paying at the original payment level, then one should come out ahead, and pay it off even sooner. (depends on the points paid to get the new loan).
I’m thinking about doing a refi myself, and hope we’d have the discipline to keep up our old payment level or close to it. Having the flexibility to drop down to a new lower minimum payment when we need to seems like an attractive option these days, too, in case my job goes away.
I love the blog, by the way – always down-to-earth and practical.
— J
January 7, 2009 at 2:01 am
Thanks Jamie. Human nature being what it is I’d not count on good intentions, even if they’re you’re own. It’s a great thought to think that you’ll pay an extra 100 bucks a month, but with so many competing interests for that c note every month…
It’s a good thought considering the job market.
One thing I can guarantee you is that whatever your mortgage payment is today it will seem like less 1, 3, 5 and 10 years from now.
Example, we moved from a 30 year to a 15 year about 5 years ago. It was brutal at first. It always is, but inflation (wage growth too) are your friends.
I always try to round up all of my monthly debt payments so my $752 a month gets a check for $800 and the $161 a month rounds up to $200.
December 27, 2009 at 6:20 am
Jamie, I have to thank you first for your time that you participate for this post. The sample and details that you describe are very informative. I had notice something that I ever though about. Thanks again.