Friday, February 17, 2012

Frugal Friday: Understanding Amortization, Part I

When we first set out to purchase a home we knew basically nothing about it. We did some research and relied on other people's advice a lot. To be honest, we were pretty ignorant, looking back on it. I talked about some of the things we learned in this process in a previous Frugal Friday post about debt, but today I want to talk a little more specifically about what we've learned about amortization and how it works.

The first step in understanding amortization is to get yourself an amortization schedule. I'm going to post some screen shots from the excel loan amortization schedule that is available to download free at this site. I like it because it is fairly clear and allows you to add on principal to your payment and shows you how doing so will save you money.

Here's a screen shot of an example amortization schedule for a house (with a loan value of $200,000). I have highlighted some information you need to know to populate the form for your own loan.

  1. Loan amount - the amount you will plug in here is the amount for your actual loan (or how much you owe on it if you're in the middle of a loan). If you're buying a house for the first time it is the amount of your house plus closing cost fees minus what you are paying out of pocket as a down payment.

  2. Interest Rate (APY) - you will probably use a lender to help you shop for a good interest rate. Once your interest rate is determined and locked in, you can plug the APY value in here. APY stands for annual percentage yield.

  3. Term of the Loan in years - How many years is your loan for? Plug it in here. If you're in the middle of a mortgage, plug in the number of years you have left to pay (decimals work for partial years).

  4. Due date of the first payment - this will be determined when you get closer to closing on the house. If you are in the middle of a mortgage, plug in your next payment date.

  5. Frequency of Payment -  Your loan can be paid annual, semi-annual, quarterly, bi-monthly or monthly. 

  6. This part of the schedule is automatically calculated - don't change it! The payment only reflects what you pay on your mortgage (not other costs like escrow accounts or mortgage interest).

  7. Additional Interest - Here you can list additional money that you put toward the principal in order to pay it off quicker than the loan term. Doing this will save you a lot of interest (especially at the beginning of the loan when you are paying a lot of interest and very little principal).

  8. Interest Savings - When you make an additional payment on the interest, you can see the savings here. This is really helpful, as you can see how much money you are saving by putting more money toward the loan. Putting even a few extra dollars a month towards your loan can really save you a lot of money in the end. For example, here I've used the same amortization schedule with $100 of additional principal added each month. You can see it really adds up.In this example, you've saved $37,094.12 in interest and have paid your home off in 24 years and 10 months instead of the full 30 years. You can see that if you add even more to the amount you are paying extra toward the principal, it will help you get out of debt even sooner.

I hope this post has been helpful and that you've been able to see how Amortization works. I plan to explain more about it in a future Frugal Friday post. I hope this will help you reach financial independence as you created your healthy family.

Linked to: Frugal Friday

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