If you have not yet done so, please read part 1, part 2, part 3, part 4, part 5, part 6, and part 7 of this series first, then read on.
I think we are at the point in this series where I should take a step back and offer a simple overview of how mortgages work. First, to show you how simple this topic is, I will offer you the “Rule of 72”. If you divide an interest rate (6% in most MMA examples) into the number 72, you get the number of years it takes money to double. 6 into 72 is 12. So at 6%, it would take money 12 years to double. Now, let’s look at the first lines of an amortization table for a $200K 30yr fixed mortgage at 6%;
| Balance | ||||
| Month | Payment | Principal | Interest | 200000.00 |
| 1 | 1199.10 | 199.10 | 1000.00 | 199800.90 |
| 2 | 1199.10 | 200.10 | 999.00 | 199600.80 |
| 3 | 1199.10 | 201.10 | 998.00 | 199399.71 |
| 4 | 1199.10 | 202.10 | 997.00 | 199197.60 |
| 5 | 1199.10 | 203.11 | 995.99 | 198994.49 |
Here, we see that the monthly payment is $1199. What would we save at the end if we sent $100 more to the mortgage? Well, 24 years is twice the 12 it takes to double, so at 6%, in 24 years we’d have $400, another 6 years, and it should be worth close to $600, right? Well, back to the amortization schedule and we see that if we pay an extra $200.10 along with the mortgage payment due for month 1, we actually get a full month ahead on our schedule. Agents selling MMA use the word ‘canceled’ for this process, saying that “MMA canceled $999 in interest in just one month.” And in a case that lies north of innumeracy, and south of hyperbole, they suggest that you got a 500% return on your money, instantly. You can see how on one hand, the math is pretty easy, you can get very close without even using a calculator, yet on the flip side, one who doesn’t understand the numbers can be convinced of something not true. $200 today is the present value of $1200 30 years hence at 6%/yr. So, you can look at this 2 ways, the extra $200 payment pays the payment #360 in advance, as it knocks off the last payment due, or looking at above, you’ve just paid payment #2, and next month, you are on line 3 of the table. The amount you prepay against principal doesn’t need to be any particular amount. If you have $100/mo extra, over one year’s time you will have paid your mortgage ahead by about 6 months. To be clear on this last thought, using a spreadsheet on your computer will give you exact numbers, but even a printed spreadsheet you track with a pencil is all most people actually need to get the job done.
Next week, we will continue and conclude our discussion of mortgage math.
Joe