Understanding Amortization

Understand Amortization to Build Wealth

by Tom Tousignant

in Blog, Financial Safety, Mortgages, Wealth Building

Last month, Fannie Mae and Freddie Mac all but ended Interest Only Mortgage loans, so the only loans left are Amortizing Mortgages.  (Some borrowers can still get an Interest-Only style mortgage, but they are very restricted now).

If you have ever closed on a mortgage, you probably remember the large stack of paperwork you needed to sign.  A large chunk of that is the “Amortization Schedule”, which is the spreadsheet that shows month by month what the loan balance is projected to be, how much of your payment goes to interest, principal and mortgage insurance if possible.

An Amortizing Loan is simply a loan where your payment never changes, but the amount you pay in interest declines each month as the principle balance is paid down. (Here in North Carolina, the banking commission makes us use two pages of disclosures in the loan application package to explain that one sentence).

The Amortization Schedule is a useful tool for an Annual Review of your mortgage.  However, there is a major problem with the original Amortization Schedule you received at closing.  As soon as you pay as little as $1 extra in principle, the remaining months on the schedule become inaccurate.

When you pay extra principle on your mortgage, you shorten the term of your loan, effectively skipping past months on the schedule.

Here are a few ways to shorten the term of your loan, if that is something you want to do:

  1. Bi-Weekly mortgage payments.  This is a separate service from your mortgage servicer that deducts half of a regular mortgage payment from your checking account every other Friday.  There are 52 Fridays each year, so this means you make 26 half payments or 13 full payments each year.  The extra payment each year shortens your loan term.  The problem with Bi-weekly mortgages is that you usually have to pay a fee of up to $400 for the privilege or sending the bank your extra payments.  It seems that they should pay you for sending in extra payments, but they don’t.  Bi-Weekly payments are handy if you get paid every other week so that you can have half your mortgage taken from each paycheck.
  2. The ‘Banker’s Secret’.  A book from a few years ago explained the so-called Banker’s Secret.  What this program did was to have you pay the regular payment on the mortgage on the due date, but add in the extra principle from the next month on the Amortization Schedule.  This skips you down the schedule every month and effectively cuts your loan term in half.  The gotcha here is that as you get later on in the amortization schedule, you have larger and larger principle payments to make extra each month.  If you aren’t earning more money each year and don’t desire to put that money into home equity, the Banker’s Secret is actually a secret way for them to get more money from you faster, so that they can lend it out again and earn more interest.
  3. Make One Extra Payment each year.  If you get an annual bonus or a regular tax refund, making one extra payment each year allows you to get the same benefit of the bi-weekly repayment plan without having to pay the extra fee.  This extra payment will go all towards principle, and not interest, so it will jump you pretty far down the Amortization Schedule each time you do it.  Maintain this practice for the term of the loan and you’ll reduce a 30 year loan to just over 24 years.

You can contact me for a free update of your Amortization Schedule – even if I didn’t originate your mortgage – I have some pretty good software to create an accurate update.

If you are a “Do it Yourself-er”, download a useful excel spreadsheet and plug in your own numbers.

Paying extra payments on the mortgage feels good for a lot of people.  Don’t fall into that trap of basing your financial decisions on your feelings!  If there are better uses of your money, such paying off other debts, building an emergency fund, or saving for kid’s college expenses – do that first.  Those beneficial decisions not only feel good, but are good for you.

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