Mortgage Borrowers Thinking About Paying Down Their Loan
Balance Should Know How Mortgage Amortization Works
Recently, I have been getting a lot of mail from mortgage
borrowers asking about amortization. Most are considering
whether to pay down their loan balance more rapidly, and
have suddenly realized that they don’t know how best to do
that, or even whether it is a good idea because they never
fully grasped how mortgage amortization works.
This article explains the essentials of amortization, and
why in today’s market it is a good idea for most borrowers
to speed up the process -- if they can.
Fully-Amortizing Payment:
Almost all mortgages today have fully-amortizing payments
(FAPs). This is a
payment which, if maintained unchanged through the remaining
life of the loan at the then-existing interest rate, will
pay off the loan over its remaining life.
The FAP has two components: the interest due the lender, and
the principal which is deducted from the balance. The
interest portion is calculated as the amount due the lender
based on the interest rate and the loan balance. The
principal portion is what remains.
An Example of the Amortization Process: The loan is for $100,000 at 4% for 30 years. The FAP is $477.42. This number is calculated from a formula that you will find on my web site, or you can use one of many calculators on the web including mine.
To obtain the interest due the lender in month 1, you
multiply the balance of $100,000 times the annual interest
rate of .04 and divide by 12 to get $333.33. The principal
payment is the residual, what remains of the payment after
paying the interest. Subtracting $333.33 from $477.42 gives
$144.09 as the principal.
Turning to month 2, the new balance is the old balance less
the principal payment in month 1, or $99, 855.91. The
interest due in month 2 is calculated in the same way as in
month 1, but since it uses the new lower balance, it is $.48
lower at $332.85. That makes the principal payment in month
2 $.48 higher at $144.57.
The process repeats each month, with the portion of the FAP allocated to interest gradually declining and the portion allocated to principal gradually rising.
Additions to the
Monthly Payment: One simple way to accelerate the payoff
process is to add some amount to the FAP. 100% of such extra
payments become principal. For example, if the payment in my
example was increased by just $10 a month, the loan would
pay off 13 months early. If the payment was increased by
$100 a month, the loan would pay off 101 months early. I
derived these numbers from calculator 2a on my web site.
Such additions to the payment are savings that yield a return equal to the mortgage rate. The mortgage borrower in my example earns 4%. If the $10 extra a month was deposited in a savings deposit, the return today would be 1% or less. That is why paying down the loan balance is a good idea.
Communicating Your
Decision to the Lender: My mail from borrowers suggests
that some are concerned that lenders will grab a piece of
any extra payment as interest. This is nonsense, the
interest payment due the lender is contractually defined in
the note, and cannot be increased. I tell some borrowers
that if it makes them feel better, they can include a note
with their payment that the extra amount is to be credited
to principal. But that is not necessary.
Occasional Larger Payments: If you hit the jackpot for $10,000 and use it to pay down your loan balance, you are again making an investment that yields the mortgage rate. There are no other investments available in the market that carry a risk-free return as high.
I have found that some borrowers
contemplating a large payment to principal worry about when
they must deliver the payment to the lender in order to
receive credit in the current month, as opposed to the
following month. Lender policies differ in that regard, and
it is worth a phone call to find out what the policy is.
A larger worry is that the lender won’t give them credit
“until the end”, meaning until the loan balance has been
paid down to the point where it equals the extra payment.
This is nonsense, a lender doing this would be committing
larceny, yet it keeps popping up in my mail.
Mortgage Amortization Tools:
Readers can develop an actual amortization schedule using
one of my calculators. For straight amortization without
extra payments, use my calculator 8a,
Amortization Schedule Including Tax Savings.
To see how amortization is impacted by extra payments of any
type, use 2a,
Mortgage Payoff Calculator: Extra Monthly Payments.
If you make extra payments and want to maintain a permanent
record of your loan, download one of my spreadsheets,
Extra Payments on Monthly Payment Fixed-Rate Mortgages
or
Extra Payments on ARMs.
The spreadsheets can be transferred to the hard drive of
your computer.
