MagicLoan – Bonus Coverage
In this month’s Property magazine, we take a look at the concept of loan amortization. Although most people tend to glaze over at the very mention of constructing a loan amortization schedule, a good understanding what is really happening throughout the life of the loan is critical to assist an investor in realizing both short and long term goals. You can read the entire article by clicking here. As mentioned in the article, loan amortization is a topic that really comes alive when using graphics so the remainder of this blog entry is devoted to additional discussion.
In the article, we talk about how the principal balance of a loan decreases at a progressive rate each month. What this means is that each month, a bit more of the monthly payment goes towards the principal balance of the loan. This is despite the fact that the total monthly payment is unchanged throughout the duration of the loan. The accompanying graphic illustrates this concept. If the loan balance decreased by the same amount each month, the line would be linear or straight. It would start at $100,000 in month 0 and ending at 0 in month 300, decreasing by the exact same amount each month. But the line is actually curved. And not only is it curved but the degree of curve changes. The initial slope is moderate but begins to really accelerate during the last third of the loan life.
The next graphic illustrates why this is happening. The loan used in the example was a $100,000 loan that was fully amortized over 25 years (or 300 months) with an interest rate of 8 percent. The monthly payment for this loan works out to $771.82. What this chart shows is that, even though the monthly payment remains constant at $771.82 for the duration of the loan, the portion of the monthly payment that goes toward the loan principal versus toward interest changes each month. In the initial payment, $105.15 of the payment goes toward the principal (represented by the green area) while $666.67 goes toward interest (represented by the red area). Halfway through the loan, at month 150, the principal portion increases to $282.89 while the interest portion decreases to $488.82. And in the final payment, at month 300, the principal portion is $766.70 while the interest is a scant $5.11. But what this graphic really shows is how the portion of payment allocated to principal increases but at an accelerating rate as the loan maturity is neared.
The last couple graphics show how changing the terms of the loan impacts the amortization characteristics. The first graph focuses on the interest rate of the loan. Both loans have an initial balance of $100,000 and both are amortized on a monthly basis over 25 years or 300 months. However, one loan, represented by the green line, carries an interest rate of 8 percent while the second loan, represented by the red line, carries an interest rate of 10 percent. Both loans start and end at the same point. However, look at what happens in between. The principal balance of the 10 percent loan is consistently higher for the duration of the loan term. Why? A look at the loan amortization schedule provides the answer. As discussed above, the payment associated with the 8 percent loan is $771.82 and, during the first month, $105.15 goes toward the loan principal. However, the 10 percent loan carries a monthly payment of $908.70 and, during the first month, only $75.37 goes toward the principal. And although both loans have an accelerating amount of principal paid each month, the total monthly amount of principal for the 8 percent loan is always greater. This is because of the interest rates associated with each loan – the 10 percent loan requires the monthly interest to equal 0.83333 percent of the outstanding loan balance while the requirement for the 8 percent loan is only 0.66667 percent. So the 10 percent loan is hit with a double whammy – a higher interest rate figured on a higher loan balance throughout the loan term.
The last graphic illustrates the impact of changing the loan amortization term. The initial amount for both loans is $100,000 and both carry an 8 percent interest rate. But the original loan, represented again by the green line, is fully amortized over 25 years while the second loan, represented by the red line, is amortized over 50 years. The payment for the 25-year loan is $771.82 and the payment for the 50-year loan is $679.27. And, while a difference of less than $100 doesn’t seem too dramatic, the impact on the respective principal balances suggest differently. I stopped the graphic at 300 months to accentuate the difference. While the principal balance of the 25-year loan is fully paid off at month 300, the principal balance of the 50-year loan is $88,101.77. That means that less than $12,000 of principal has been paid off at the loan’s halfway point. So what is happening here? Again, a quick comparison of the respective loan amortization schedules tells the story. In the first month, the interest portion associated with both loans is identical – $666.67. However, the 25-year loan has $105.15 applied toward principal while the 50-year loan has only $12.61 applied toward principal. And its no coincidence that the difference between the principal portions associated with both loans is exactly the same as the difference between total loan payments associated with both loans.
I just love it when a plan comes together.
