Friday, March 28, 2008

Amortization schedules show the real problem

Financial Advisors love to flaunt the power of compound interest, that is the amount of interest money can earn over time when you earn interest on the principal and interest that exists. If you look at an amortization schedule, you will see the opposite, almost a negative compound interest thing happening.

First, an example. Using an Amortization calculator and Freddie Mac's current weekly average mortgage rate of 5.85% on a 30 yr loan starting in April of let's say $150k, you will find I would pay off the first half of principal in February of 2029 making the minimum monthly payment. Thats almost 21 years to pay off $75,000 at almost $900 per month! By the end of 30 years, the total interest paid is over $168k!

While changing the principal doesn't change when you pay off half, your interest rate does. If you have a higher mortgage rate, lets say pay off half in December of 2029. So, when you pay off your first half of your mortgage varies from about 20-22 years based on the current interest rates.

Now, in the past people have paid little to no attention to these schedules. Its because paying off principal wasn't an issue when houses were growing at 4% compounded annually. But, with the recent housing market growth slowdown, I hope that more people pay attention to it. If someone gets a 100% financed $150k house now and prices only go up 1% per year for the next 3 years and then they try to sell it, they will have paid off roughly $6.5k in principal and gained about $4.5k in value on their home. So, if they sell it at that $154,500 with a standard Realtor fee of 6%, they will pay $9,270 in Realtor fees. This will leave them with a whopping $1,730 check for paying $32,400 in mortgage payments not including PMI, homeowners, and taxes. Sure, they will also have got a small tax deduction during that time...but I think they might have been able to rent and save more money.

Just as a matter of opinion, look at your amortization schedule and consider dropping some more money into your mortgage monthly. Maybe you can pay off the first half a bit quicker than in 20 years then :-)

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