Is there ever a “smart” loan to take out?
According to our friend Dave Ramsey, “Debt is dumb….” This is generally true because “the borrower becomes a slave to the lender” (Proverbs 22:7), paying handsomely for the loan over time in the way of interest payments. Though we do not recommend taking on debt, we will analyze one specific type of loan structure associated with the home mortgage, the amortized loan, and how you can make the most of it.
An amortized loan has scheduled payments applied to the loan’s principal balance and interest. “Amortize” refers to the gradual payoff of a loan (or asset) over a certain period. While we do not recommend taking on debt, the home mortgage is the exception to the rule.
Despite being an exception, it’s essential to have a plan to pay down that loan as quickly as possible. That plan is also known as an amortization schedule. An amortized loan front-loads the interest payments in the earlier periods, with the remaining amount devoted to reducing the principal balance. Then, as time passes, the interest payments get smaller, and the principal payment increases. This structure is designed to benefit the lending institution in the early days of a loan, allowing them to capitalize on even the most aggressive borrowers who intend to pay off the debt early – a strategy you should do your best to employ.
While there is little you can do to reduce the initial interest payments on an amortized loan, you can still benefit from an aggressive strategy about paying off your mortgage early. The interest calculation is based on the loan's current balance, so the interest amount decreases incrementally as payments are made. So, when you pay additional principal payments, the calculation changes, and you wind up saving money on interest over the course of the loan.
Here is how the calculation works:
Multiply your current loan balance by the interest rate (divide the annual rate by 12 for the monthly rate) = Interest due for the current period.
Suppose you’re buying a $250,000 home with a 15-year annual fixed-rate rate of 6.5%, and you made a down payment of $50,000 (20%).
Here’s an example of how that calculation works:
$200,000 (principal balance) x 6.5% (annual interest rate) = $13,000 (annual interest amount)
$13,000 (annual interest amount)/ 12 months = $1,083 (current month’s interest amount)
$1,742 (monthly principal and interest payment) - $1,083(current month’s interest amount) = $659 (current month’s principal amount)
If you pay extra principal during a given period, that amount will be deducted from the loan’s principal balance, affecting the calculation and resulting in a lower interest payment for the next period. If you do this consistently, you will significantly shorten the length of your mortgage term and build equity much faster. As you can see, it is worth looking at your budget and reallocating some spending to additional principal payments. An amortization schedule is another budgeting tool that can set you on the path to financial freedom.
If you’re interested in tackling baby step 6 and being what Dave Ramsey calls “weird people” (the good kind), talk to a financial advisor or financial coach to see how an early mortgage payoff might impact your financial future.
WHAT IS AN AMORTIZED LOAN?
June 25, 2023
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