Amortization: What is it and How to Calculate it?

The vast world of debt has many Americans today in a hole deep enough to keep them in an unsafe position financially for years. There are good debts and bad debts and sometimes debts that are a necessity. 

Today I want to talk about the word, amortization. Maybe you have heard this, maybe not but it is a very important topic for any type of loan. It is a great way to figure out your budget when getting a loan to decide what monthly payment you are comfortable with and how much interest you are paying with that payment. Also, it lets you know how much to pay if you can pay it off quicker and save a ton of interest in the process. 

You can also use an amortization calculator online but if you are a financial nerd like myself, you can use the amortization formula.

Let’s say we buy a car for $30,000 and put down $5,000.  Our loan needs to be $25,000 and we get a decent interest rate of 5.75% on a 5-year loan term.

This punches out to a monthly payment of $480.42 multiplied over $60 months it is $28,825.15 total payoff which is $3825.15 of interest. 

The number of months is the magic number you can change to see how much you need to add to the monthly payment to pay off quicker. We can change it to 48 months and our payment will be $584.26 per month. For a total of $28044.69 total payoff saving $800 in interest and done 12 months quicker. Being on both sides of the car payment life I much rather pay it off as fast as possible if the budget allows. One less thing to worry about. 

I just want to add this part for some education. There is a bragging car salesman on Instagram putting people in $25,000 cars for no money down, bragging about getting these first-time buyers a 17% interest rate. Doing the math, we will see how predatory these rates are. Over a 6-year term, these numbers shake out to a monthly payment of $556.15. With a final payoff of over $40,000 on a $25,000 loan…. $15,000 of interest paid while being locked up for 6 years of payments. Shop around interest rates. Don’t get googly-eyed over the car brand for your age and income. These loans are extremely predatory, be smart. Please do lots of research to avoid these scammers.

Most of my audience is younger and not quite in the home-buying market, which is okay, rates are terrible at the moment anyway. Focus on saving and getting out of debt. A home purchase is a big financial goal for most people so we need to be aware of amortization and how an extra $100 dollars a month can save you tens of thousands of dollars in interest and pay it off 6 years quicker. 

Interest rates are tough today, they have ballooned up to 7% when a similar loan was getting 3% a couple of years ago. In the housing market, this will be the biggest purchase of your life most likely, and these interest rates can balloon the monthly payment and interest paid throughout the loan. 

For example, if we use the same formula for 2020 rates and 2024 rates on a $350,000 house the difference is insane. 

We will also be using a first-time home buyer loan which you have to put down 3.5% for $12,250 and a traditional loan of 20% down of $70,000.

This does not include insurance, taxes, or utilities, it is strictly just principal and interest!!!!!

The monthly payment of for a 20% down 30-year 7% interest is $1,862.85 total cost is $670,624.92. Total interest paid: $390,624.92

The monthly payment for a 20% down 30-year 3.5% interest rate is $1,257.33 for a total paid of $452,637.05. Total interest paid $172,637.05. 

Well over double the amount of interest paid. The first-time home buyer rates are even wilder.

The monthly payment for a 3.5% down 30-year 3.5% interest is $1516.65. Total paid $545,993.44 

Total interest $208,243.44

Monthly payment for 3.5% down 30-year 7% interest is $2,247.06 total interest paid is $471,191.30

Total paid is $808,941.30

For a $350,000 house….

Pretty crazy to see how much you have to pay with a crap interest rate. Also, see how important a down payment is. Don’t rush yourself into a house. It is an extremely expensive venture and more headaches if you go too fast. 

Paying the house off early.

\Which means we are paying it off 5 years early. On a 20% down, 7% interest $350,000 house on a 25-year mortgage is $1978.98. $116.13 more than the other monthly payment. You will also save $76,930.39 in interest finishing 5 years early. 

These types of secrets are when math gets exciting. If you pay a little over $100 a month you can save so much. My goal is to buy a house when I’m 30-34 and have it paid off by 50 years old. Once you hit 50 you can use that extra money not going to your mortgage for maxing out retirement vehicles using catch-up contributions for a Roth IRA with an extra $1000 per year to catchup.  401(k) with an extra $7500 as of 2024. At 55 years old for an HSA catchup of $1000 extra a year. This can go a long way if you have fallen behind. Even without interest paid, you can save $300,000 in ten years in your 401(k). 

Without a mortgage and at the height of your career pay you could hit the $42,000 number as of 2024 to max out all retirement. A good rule of thumb is 20% going to retirement but run that by a financial professional, this is just what I have researched. 

Dave Ramsey has a different philosophy than the traditional 30-year fixed-rate mortgage. He speaks on 15-year mortgages. 

Using the same formula and same 20% down 7% interest over 15 years the payment will be $2516.72 per month. With no taxes. No utilities. No HOA. No insurance. Strictly interest and principal. This will decrease your interest by ALOT, but it just isn’t available for a majority of people. The median household income according to the census in 2022 is $74,580 post-tax dollars. This is an average of $6215 per month and this is about 40% of your income tied up in principal and interest. It would be a very scary situation to do this. House poor is only the beginning, just wait until the A/C craps out and you have to shell out thousands of dollars in repairs. 

If the only way you can afford a home COMFORTABLY is a 30-year fixed rate mortgage and pay quite a bit of interest that is just what you have to do. Your home is going to be one of your largest assets and even if you have to pay interest on it you will own a home. 

Play around with amortization schedules and calculators when in the market for these. You might be surprised how well you can game it to get a payment that fits within your budget.