Back in 1999, lodged between Braveheart and his permanent fall from grace, Mel Gibson starred in a gritty action film called Payback. It’s probably one of those movies you saw one Sunday afternoon while half asleep on the couch. But as you may have guessed from the title, some bad people owe Gibson’s character some money; needless to say, he gets his money back. With much less fanfare, banks get their money back through a process called amortization.
If you took Latin in high school, you may think it has something to do with love (amare), but if you’ve ever taken a finance course, you know it’s that thing with loans that no one can ever pronounce (ə-mor-tə-ˈzā-shən). Amortization is the process of slowly chipping away at your debt, one payment at a time. When you take out a mortgage, they will even give you a schedule that details every single payment you will make throughout the life of the loan.
And that schedule is important because it shows you that not all payments are equal. At the beginning of your loan, the majority of each payment goes toward interest, which even if you understand conceptually, the numbers can still be shocking. For example, if you take out a 30 year $200,000 mortgage at 4% to buy a new home. In the first year, of the $11,500 in payments that you will make, only $3,500 goes toward principal. So even though you have lived in your new house for a year making monthly mortgage payments of close to $1,000 per month, you still owe the bank $196,500.
But here is the reason why: banks don’t give you money out of the goodness of their heart. Regardless of what the slogan in their mortgage department may be, they are not in the business of making your dream home a reality—they are in the business of making money. Don’t get me wrong, I am not faulting them at all; they provide a much needed service and should be compensated accordingly.
But since they are willing to give you $200,000 for your dream home, they expect 4% of the current outstanding balance. So at the beginning of the loan, they charge 4% of the full $200,000. After the first year, you have chipped away $3,500 of the loan principal, so they charge 4% of $196,500. Finally, in the last year of the loan, there will be just over $11,000 left in principal, so only about $500 will go toward interest and the rest toward principal. That is how loan amortization works.
However, you can almost always make pre-payments, which can significantly reduce the time it takes to repay the loan and the amount of interest you ultimately end up paying. For example, if you make one extra payment per year on the $200,000 loan, you could pay it back about four years early and save $20,000 in interest. Some people make the extra payment with their annual bonus, but another strategy is to make half payments every two weeks. Since there are 52 weeks in the year, that would result in 26 half payments or 13 full payments, which would get you to the same result.
People dream of owning a home, but they should also dream of owning a home outright with no outstanding mortgage. In order to do so, consider making accelerated mortgage payments a part of your overall financial plan.
Josh Norris is an Investment Advisory Representative of LeFleur Financial. Josh can be reached at josh@LeFleurFinancial.com.