We are going to dive into amortization - the process by which your monthly loan payments for your home are set. If you understand this, you should be able to make better decisions around interest you pay, etc.
How Amortization Works
In an amortized loan, each month the amount you pay goes a bit towards principal and the balance towards interest. In the early payments, you are mostly paying interest with smaller amounts going towards principal. Towards the end of the loan term, the situation is reversed - bulk of the monthly payments goes towards principal with small amounts toward interest.
Simple example: Let's say you get a 30-year fixed mortgage at 4% on a loan amount of $200,000. Then, your monthly payment of $954.83 is split up as follows:
| Month | Principal | Interest |
|---|---|---|
| 1 | $288.16 | $666.67 |
| 2 | $289.12 | $665.71 |
| ... | ... | ... |
| 357 | $942.20 | $12.63 |
Loan Choices - An Example
Now let's say you are looking for a home loan. You get two choices:
- Choice 1: 30-year fixed loan of $200,000 at 4%.
- Choice 2: 30-year fixed loan of $180,000 at 4%. You put an additional $20,000 toward down-payment.
Which one should you choose? Assume that all other terms are equal...Let's run the numbers.
-
Choice 1: Your monthly payments will be approx. $955. Total interest paid over the life of the loan will be $143,739 - more than 70% of the loan amount!
-
Choice 2: Your monthly payments will be approx. $859. Total interest paid over the life of the loan will be $129,365. Again more than 70% of the loan amount!
Obviously, Choice 2 is better - you are paying almost $15k less in interest!
But can you do better without more money or better negotiating skills?
Yes, you can, as a matter of fact! In this choice 3 you get a 30-year fixed loan of 4% for $200,000 - exactly like Choice 1. But you now take the $20,000 (as you did in Choice 2) and make an ADDITIONAL payment towards principal in the first month of the loan itself. In this case, miraculously the total interest paid is ONLY $104,206!
Note that this is less than Choice 1 total interest paid. But it is also counter-intuitively less than Choice 2 - where you took a smaller loan to begin with!
This is almost like magic - but it is not. It is merely a function of how amortization works. Remember in amortization, each month more of what you pay goes toward principal (and less toward interest) - so when you make this additional payment towards principal, you leap ahead in the amortization schedule (in our example, you leap ahead 64 months) thereby paying less interest going forward. Furthermore, each month you are paying more toward the principal (because your monthly payment is larger to begin with - $954 vs $859) - contributing additionally to the lower interest overall.
Key Learnings
- First Make sure you get a loan that allows early pay-off without penalties. Sometimes, lenders explicitly forbid this in loan terms.
- Second it's better to take a larger loan and make an additional payment towards principal than to take a smaller loan at the same interest (all other terms being the same, of course)!
- Third - this works even when refinancing.
- Fourth - remember, as always, to read the fine print so that when you get the larger loan amount, you are not paying PMI, and other fees, etc.
Good luck!
Submitted November 11, 2017 at 06:46AM by arnexa http://ift.tt/2mfT0U7
