An amortization schedule is a list of all the payments one will make on their mortgage. Mortgage interest is charged on the unpaid balance of the loan and is recalculated every month. The monthly payment remains the same but the portion of the payment owed for interest is reduced every month because the interest is figured on the unpaid balance. The portion of the payment credited to reducing the debt increases every month. A graph of the way principal and interest is applied over the life of the loan makes a big "X" with the interest (blue in the chart below) being high in the beginning of the loan and low at the end and the principal (red in the chart below) being the reverse.
Some clients ask about paying off their mortgage before the full 30 year term. There are several ways to do this. The easiest is to add extra money in each payment to be applied to the principal. Some lenders provide a bi-monthly payment plan which shortens the life of the loan as well.
When my husband and I purchased our first home, our lender suggested we pre-pay the mortgage by using an amortization schedule and paying the next month's principal as the extra amount on our payment. Never having heard of an amortization schedule, let alone seen one, my brain didn't get this concept. Lender Bob whipped out a partial amortization schedule like the one below to demonstrate.
"It's quite simple," says Lender Bob. "On your amortization schedule, your normal payment is in yellow. If you add the principal from the next month's payment (green on the chart) as extra principal, you have just shortened the term of your loan an extra month without having to pay that month' interest. You can't skip the next month's payment because you did this. You still have to make one payment each month until the loan is paid off. So, for your second month's payment the red square is your regular payment. Paying the blue amount shortens the life of your loan by another month. By making only those two payments, you'll have 356 payments left instead of 358."
Now that seemed like a plan to me. I like instant gratification. Making a willy nilly extra hundred dollars here and there didn't seem like progress to me, but knowing I had chopped off two extra payments that would have cost $2,462.86 by paying only $383.51 made a lot of sense.
We quickly learned this system only works for the first few years of the loan as the principal amount increases each month. We successfully pre-paid for a few years and then had to go back to the normal system of adding a couple hundred extra dollars each month instead of the next month's principal amount. As we approached the vortex of the payment distribution in the first chart, our budget forced us to abandon our lender's system!
That makes sense, very interesting concept and it saves you a ton of money!
Posted by: Chris K | October 11, 2007 at 10:57 PM