The Magic of Amortization

The Magic of Amortization

| January 24, 2023
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Amortization is the calculation by which you pay off any loans you have. This calculation figures out given your time length, starting loan amount, and interest rate, how much you will need to pay each month to have the loan paid off. Well, the magic of this formula is if you take a marginal step forward towards paying more towards the loan every so often, it can dramatically reduce how long it will take to pay off the loan.


How it Works

The amortization calculation tells you your monthly payment to pay off the loan in the agreed upon time frame. If you were to pay slightly more than the required amount, then the next month when interest is added, the loaner won’t be able to charge as much interest because the outstanding loan amount is less than expected. Then the next month the loan amount is still less than expected, and as a result there is even less interest charged in this month. This trend continues into perpetuity with you saving interest every month forever because you paid more than you needed to one time. Now you can continue paying the standard repayment amount each month, and then due to less interest accruing the loan will end up being paid off sooner than expected.


Now let’s take this scenario one step further. What if you systematically set yourself up to pay a little bit extra each month? What if you go as far as paying one full extra monthly payment per year? Of course, the more extreme you go with paying extra towards the loan, the more you will be able to take advantage of the magic of amortization.


Mortgage Example

Let’s look at a real-life example. Imagine you have purchased your first home, and have accepted the 30-year payment plan. The loan officer calculates your principal and interest payment each month for the duration of the 30-years, and tells you your monthly payment. Now, what if you login to your payment portal and automatically set yourself up to pay an extra payment each April because you typically receive your annual bonus this month? Or, if you don’t receive a bonus, you set it up for April because you know in the first 3 months of the year you have the capacity to save a little bit extra each month. With this one extra monthly payment for the year, you will now have your mortgage paid off in about 24.5 years. In other words, you are going to save more than 60 monthly payments (5 years) over the course of the mortgage all because you paid an extra 25 monthly payments! This is an incredible opportunity to save yourself from interest while simultaneously shortening the loan term! In our example, let’s say this is a 30-year mortgage for $300,000 at 6% interest. If you paid this off normally, you would end up paying $347,000 in interest.  However, if you paid one extra payment each April, then you would pay an extra $44,950 towards principal over 24.5 years, and these extra payments would save over $76,000 in interest! So not only do you have an extra 5 years without a mortgage payment where cash flow will be great, but you will have saved a net of roughly $21,000 over the years in interest. This is an incredible opportunity to cut down on interest paid while simultaneously giving yourself extra cash flow later in life.


Some people may be reading this with an interest rate at 3%, which makes their loan seem pretty cheap compared to today’s rates closer to 6%. However, having the knowledge of how you could accelerate your mortgage payment, or any debt payment, to get yourself closer to being debt-free is a valuable tool to use when assessing your future financial decisions.


Conclusion

Understanding how amortization works is a very powerful tool in helping yourself to become debt free. I strongly recommend you speak with your financial advisor about how to speed up the amortization process for any of your outstanding loans, and come up with a plan to put the magic of amortization to work! If you would like to further discuss your financial situation then please call our office at (734) 681-7575 or email me directly at preston@peakwm.com.

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