Amortization is probably one of the most ubiquitous financial concepts that encompasses our daily lives, but yet, few of us know what it means, how it works, much less, how the monthly payments on all our stuff is calculated.

By definition, amortization is:

The reduction of a debt over time by making periodic payments (usually monthly), where depending upon the length of time the loan is held, a portion of each payment is paid to interest and a portion is paid to reduce loan principal.

Mathematically, you can use several different variations of the same equation, but I feel the easiest amortization equation is one that you might remind me of something you would have seen in your high school algebra class.

If you’re algebra skills need some refreshing, nothing works better than a piece of paper, a pencil and a scientific calculator. If you’re more experienced with spreadsheet program like Microsoft Excel or Open Office Calc (FYI – Calc is free), then you can simply plug and chug the equation whatever variables you need.

Putting this equation to work, let’s assume you’re applying for a 30 year mortgage at a 6% interest rate totaling $200,000. The equation would then look like:

The resulting answer would equal a monthly mortgage payment of $1199.10, not including insurance, taxes, PMI and other fees.

Examining this a bit further, here is a closer look at what your amortized payment schedule (broken down in 5 year increments) would look like:

Hat tip to Bret Whissel and for his easy to use Amortization Calculator.

Seems like pretty boring stuff, right? Probably so.

Until you realize that you’ve been in the same house for 10 years and you’re still paying more in interest (e.g. bank profits) than towards your loan principal.

Negative Observations

By taking a look at the amortization schedule, several things should pop out at you.

1. In your first mortgage payment, you’re paying slightly more than 5 fold of your payment in interest rather than repaying principal.
2. It takes 222 payments, or 18 and half years, of paying the minimum monthly payment, for the amount of interest paid and the amount of principal paid in your monthly payment to roughly equal one another (see yellow highlights in amortization schedule).
3. On a $200,000 mortgage, the cumulative total of all your monthly payments will total $431,676.00 (assuming you pay minimum monthly payments).
4. On a $200,000 mortgage, you will pay $231,677.03 in interest payments alone (assuming you pay minimum monthly payments). You will get a tax deduction on interest paid, but the figures are still worth noting.
5. If you only pay the minimum monthly payment and you repay the mortgage in full, you paid roughly 116% of the original mortgage value. That’s more than double the loan amount.

Naturally, these are some of the negative observations when considering to taking out a mortgage. However, like most things in life, there are two sides to every coin.

Positive Observations

There are definite positives to taking out a mortgage.

1. With a fixed interest rate, future inflation is definitely your friend. Meaning that the cost of your living expenses (your mortgage) will decrease over time as your salary increases and your native currency slowly loses value.
2. You have a place to live that, one day, you may own free and clear.
3. Since most people don’t have $200,000 just lying around, taking out a mortgage to reduce the high barrier to entry to home ownership is the next best thing.
4. The interest paid may be deductible on your income taxes.
5. If you’re a real estate investor, you can use amortization as leverage. For example, if your monthly rental income is higher than your the monthly mortgage payment on your investment property, you’re generating positively monthly cash flow and an annual profit on your investment.

Final Thoughts

I hope this basic personal finance equation gives you some insight into why you’re paying the amount of money you’re paying on your largest assets every month.

Obviously, using the example of a traditional 30 year mortgage is, in my opinion, the best way to show the positive side of amortization since it applies to a large percentage of the general public.

However, the amortization equation also applies to other large price tag items that impact your monthly budget. Such as, your car payment, student loan(s), and if you’re carrying a balance on your credit card, how much interest you’re paying every month.

Depending upon your point of view when it comes to your debt, you can use the amortization equation as a positive motivational tool for wealth building (by leveraging low interest debt to generate positive cash flow or on must have items) or as a negative motivational tool to keep yourself out of debt by avoiding high interest debt (paying 25% interest on credit card debt to buy more stuff).

Either way, when taking on new debt in the future, you should now know how much of your money is actually going to repay what you borrowed, and how much is ends up as bank profits. As this example shows, the answers might surprise you!

Share

2 saves

• Living Beyond Your Means: School Bus Driver Losing Her $800,000 Home to Foreclosure
• Best Reads and Impatiently Awaiting Decision on the Big Three Bailout.
• Personal Finance Equations You Should Know
• Strategic Defaults: I Hate to Say 'I Told You So' but...

• Saving Money with a Government Loan Option
• Figure the interest
• 4 Tips to Getting Bad Debt Under Control
• What Benefits Can Debt Settlement Offer?