Yesterday in Part 1, we talked about the basics of amortization and mortgage prepayment. In this post, I just wanted to share some other interesting results I got when tinkering around with the amortization schedule.
Are you always paying the same amount of interest?
As I noted before, amortization is a way to make equal payments but still preserve the right ratio of principal paydown and interest. You can check this using the same schedule of payments as before, except now I’m just looking at it broken down by 12 years instead of 360 months. ($200k mortgage, 30-year fixed at 5%).
If you have a loan of $200k at 5% interest, simple arithmetic will lead you to guess you’ll pay around $10,000 of interest the first year. As you see above, during the first year you actually pay $9,933 towards interest, as your loan balance went from $200,000 down to $197,049 over time. If you simply divide the $9,933 by the average of $200,000 and $197,049, again you’ll get 5%.
This just provides a rough estimate, but you can see that you’re always paying 5%, even as the principal shrinks. Only at the very end does it vary slightly, not sure why exactly, but I’m guessing due to smaller numbers. The lender isn’t ripping you off by having you pay a ton of interest in the first year. You just have a lot of interest to pay! Kind of neat, actually.
Is your investment return from paying extra towards principal really the mortgage’s interest rate?
When you pay down your mortgage at 5% interest, it is often assumed that this is the same as investing that cash elsewhere and earning 5% per year. (Ignoring tax issues.) But is it?
Again, a quick check on the spreadsheet confirms this. Let’s say I am just starting Year 2. If I prepay the entire equity portion of $3,102, this will advance me to Year 3 of the schedule, and I will be shaving off one year from my mortgage. In other words, my $3,102 will be worth an entire year’s worth of payments, or $12,884, in 29 years. This works out to be the same as a 5.03% annualized return. Close enough for me. Again, if you prepay near the very end of the term, the percentage starts to drop off a bit. But remember, if you’re prepaying, you’ll probably be finished with your mortgage well before reaching that point.
I’ve plotted both the effective interest rate paid and the paydown investment return (gain) below:
You can play with the spreadsheet yourself at Google Docs or in Microsoft Excel format.
Read more about Amortization Schedules and Principal Prepayment, Part 2: Verification…
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