Friday, June 29, 2012

Frugal Friday: Understanding Amortization, Part II

A few months ago I shared with you my experience with debt. Then in a later post, I talked about amortization and how to use an amortization schedule to help you get out of debt. Today I want to come back to this topic and discuss it more because I have more to share.

A quote attributed to Carlyle says, "Debt is a bottomless sea." And I can certainly relate to that feeling, can't you? When you're in debt it's hard to see the way out of it. You think it will last forever! And it can, if you're not actively trying to get out.

One of the most important things that we have done to get out of debt was to set goals. Reachable goals, but goals that stretched us and made things a little uncomfortable for a while. We decided that until we got out of debt, we focus as much as we could on buying only necessities and put our excess income towards paying off our debt (our house in this case).

We sat down with an amortization schedule and mapped out how soon we could feasibly get out of debt with our current income. By adjusting numbers and plugging them into the amortization schedule, we were amazed at what a difference putting even a couple hundred dollars a month extra toward our loans could make. We discovered that we could cut our debt time to half or even a third or a quarter of the term of the loan by simply paying extra on our principal each month.

As I mentioned before, it's important not to wait to do this. It's easy to think, "I'll just save the money and pay off the loan in one big lump sum at the end." But you have to understand the way amortization works is that the most critical time to save money on your loan is right up front at the beginning of the loan. That's where it really makes a difference. Let me see if I can explain using a theoretical example.

In this example I'm using the downloadable amortization calculator from this site, but you can use any amortization calculator that you like. Here's an screenshot of a theoretical 30-year loan amortization schedule for a loan of $200,000. The annual interest rate is 5%. This screenshot shows no additional principal payments - just a monthly payment of $1,073.64. This example will be the base point for my next four examples.

EXAMPLE 1: Extra $100/month for the lifetime of your loan

Now in this next screenshot, I'm showing what will happen if you take the same loan and now pay an additional $100/month right from the beginning toward the principal. As you can see, you will save $37,069.03 in interest by doing this and will cut your loan time by over 5 years, which is significant! Putting more towards your loan every month, obviously will save you even more and reduce the amount of time you will be in debt.

EXAMPLE 2: Paying it off at the end

Now imagine that instead of putting that $100 toward your principal payment each month, you put it in the bank and decided you would use that money to pay off your home at the very end. In the previous example, you would have put a total of $29,700 toward your house extra principal over the course of the 25 years. So if we put that much in the bank and pay it off at the very end, here's what we come up with. You are only saving $13,527.76 in interest this example, by putting roughly the same amount of money towards your house as in the previous example. Just at the end instead of steadily throughout the life of your loan. You can see that this really does make a difference. While you may be able to generate a little bit of interest on the money you put in the bank, it will no where compare with the amount of money you can save yourself, by putting a little towards your loan every month from the very beginning. Note that this also only cuts your loan time by about 3 years instead of 5 with the same amount of money.

EXAMPLE 3: Extra $200/month at the end of the loan

In this next screenshot, I've started after 170 payments to put $200 toward the principal. This is the example where maybe you don't think you can afford to put any money up front, but try to make up for it at the end. You are putting roughly the same amount of money as the other two examples (about $29,700 total). As you can see this saves $15,190.85 in interest. And cuts your loan by 4.5 years. While you are out of debt at roughly the same time as example 1, you save less than half the interest by paying it off at the end instead of consistently throughout the lifetime of your loan.

EXAMPLE 4: Extra $200/month for the first half of the loan

In case I haven't convinced you yet, I'll share one more example. In this example, I'll put the same amount of money toward the loan (about $29,700 total), but pay $200/month for the first part of the loan and then stop paying any extra for the rest of the loan. As you can see, this example saves the most in interest of $54,102. And you've cut your loan by 6.5 years. We could extend this to show that the more you put up front will make more of a difference to saving you money than the total amount extra that you spend.

Hopefully through these examples, you are getting a sense for how amortization really works and how you can use it to help your family get out of debt and save money. Knowing this information and applying it to your own debt can literally save your family thousands of dollars in interest. Remember, healthy families are financially healthy as well as physically healthy!

I'd love to hear any ideas or comments about your families experience with debt or how you save money. Thanks and have a wonderful day!

Linked to: Frugal Friday, Thrifty Thursday, Homemaking Linkup, Hearts 4 Home


Crystal @ Serving Joyfully said...

I recently played around with this as well, in planning how we could get out of debt faster...I have a series on my blog going right now about getting out of debt on a low income, and I did the exact same thing, I just plugged our numbers into an amortization calculator and figured out how we could save the most money...just paying $25 extra per month on our $65,000 mortgage was going to save us 5 years and over $10,000 in interest...craziness.

Mom as Doctor said...

We don't have any debt besides our house but are working towards paying that off. Thanks for the post!

Anna @ Feminine Adventures said...

Wow! I've wondered about this but you made it quite easy to understand. We are buying a house because rental prices are SO high where we are looking but want to pay it off as quickly as possible. We were already planning to throw as much as we could toward it from day one but this gives extra impetus.

Thanks so much for sharing at Thrifty Thursday!

Lisa @ Stop and Smell the Chocolates said...

Great examples! We are trying to figure out how much extra to pay per month and how soon we could pay off our mortgage - just amazing how much money you can save!

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