If you’re just stopping by for the first time, this is a class in a series of classes over the next few months which will culminate in the development of a complete financial plan. Stop by the orientation class HERE first for class orientation/overviews and HERE for more information about the website.
Class Objectives: To understand how debt amortization schedules work on non-revolving loans (such as mortgages, auto and student loans)
Prerequisites: PF101: Intro to Personal Finance & Goals, PF102: Creating a Net Worth Statement, PF104: Creating a Budget & Cash Flow Statement, and DM101: Debt Overview & Credit Cards
Handout: Debt Statistics in the U.S.
Assignment: Debt amortization schedule in Excel | Google Docs
We talked about what debt is and more specifically about credit card debt in the last class. In this class, we will cover more about non-revolving loans and how to make a plan to eliminate your debt other than credit cards. In almost every situation, you should get rid of your credit card debt before paying extra on your auto loan, student loan and mortgage because credit cards carry a much higher interest rate than these other loans.
The most important tool we are going to use in this course is a debt amortization schedule. Although similar principles were used in the credit card payoff schedule in the prior class, debt on these loans is treated differently specifically in regards to having a set pay off date and not being able to add to the principle balance over time.
When you take out a student loan, auto loan or mortgage, you will be expected to pay a set amount of money that you borrowed over a determined amount of time plus interest for the privilege of borrowing that money. If you choose to do so (yes, you choose to do so, alright?!), then you can pay extra towards the principle amount you borrowed and pay the loan off early. Let’s back up and talk about some of the terms involved in these loans really quickly.
- Lender – the person paying the funds on behalf of the person that needs them (for example, you may have an automobile loan through Ally Bank – they are the lender).
- Borrower – the person that the funds are being paid on behalf of (aka YOU).
- Original principal balance – the amount you borrowed initially (for example, if you purchase a $25,000 car and pay $1,500 down, your original principle balance will be $23,500).
- Current principal balance – the amount of the original principal balance that has not yet been paid (in the previous example of an auto loan, after a year at a 3.5% interest rate for 60 months, your principal balance will be down to $19,123).
- The loan period – The amount of time during which you will be paying the payments, assuming you do not pay any extra payments (for example, 60 months)
- Monthly payment amount – the amount you will be paying each month, which will include both part of the principal balance and interest (for example, each monthly payment on this auto loan example will be $427.51 and your first monthly payment will consist of $358.96 principal and $68.54 interest).
- Interest rate – the percentage expressed as an annual rate of the current principal balance that you will be paying to the bank or lender (in our example, this is 3.5% annually)
- Prepayment penalty – a fee that you are required to pay if you pay off your loan before the original loan period date (for example, if your 60 month auto loan has a prepayment penalty attached of $300 and you pay off the loan in 55 months, you will be required to pay an additional fee of $300 on top of your principal balance)
HOW DOES AN AMORTIZATION SCHEDULE WORK?
A loan amortization schedule is an important tool used to track how much you currently owe on your loans and the amount of interest you’ve paid. For the non-revolving loans we are talking about today, the payments are the same each month, but the amount of that payment that is applied to the principal balance and the amount that is applied to interest is different for each payment.
The non-revolving loans that the amortization schedule is useful for include:
- Mortgages (this is the one people typically think of when they think of an amortization schedule)
- Home Equity Loans
- Automobile or Boat Loans
- Student Loans
- Other installment loans
It’s helpful to see how the payments are calculated to be able to understand these loans.
- The monthly payment calculation uses time value of money calculations to figure out what monthly payment amount will result in a loan being paid down to zero over a set period of months or years. A spreadsheet or calculator is essential in calculating this figure.
- Once you have the monthly payment, you divide the interest rate by 12 months to get the monthly interest rate. This percentage (.292% in our auto loan example) is then multiplied by the current amount owed on the loan to get the amount of the monthly payment that goes to the lender for interest on the loan.
- The remainder of the monthly payment after calculating the interest portion goes to the principal balance of the loan.
- Any additional payments made for the month decrease the principal (it is sometimes necessary to specify this to the lender) and therefore decrease both the amount you’ll pay in interest and the time it will take you to pay off the loan
As you can see, in the early months most of the payment is applied to interest, but over time a greater portion of your monthly payment is applied to the principal balance of the loan. You can see that in the following example schedule:
WHAT ARE THE BENEFITS OF COMPLETING AN AMORTIZATION SCHEDULE?
There are many benefits to completing this exercise and creating amortization schedules for all of your loans. The most significant benefits include:
- You will know your current balance owed at all times (especially helpful for creating your net worth statements quarterly).
- You will know how much interest you’ve paid for the year to be able to project your tax deductions for the year (for home mortgage loans and student loans).
- You will make sure that any extra payments you’ve made on the loans have been properly applied to principal and not future interest or other fees.
MAKING AN OVERALL DEBT STRATEGY & REFINING YOUR DEBT GOALS
Start with your credit card debt payoff strategy in the previous course before looking at how to pay off your longer term debts. Then look at your budget, assuming that you have paid off that high interest debt and decide how much of those previous minimum payments and extra payments you’ve been making that you want to apply to your additional debts. If you’re really motivated to get out of debt, you may decide to put all those funds toward your remaining debt. If you need a little more breathing room in your budget, you may decide that 50 or 75% is more sustainable. Do what works for you and focus on progress!
If your budget is tight and you’ve had to be extremely frugal to get your credit cards paid off, you may decide to relax a little and minimize the stress for a while. As long as you’re not adding to your debt, celebrate the progress towards being debt free and be sure that you are able to enjoy time with your family and friends. Then jump back in and begin your next step to becoming debt free, which is to eliminate your long-term debt.
Generally your priority for your remaining loans should be to pay extra on your consumer debt, such as an automobile loan next. However, this depends on the interest rates and balances owed on your remaining loans. Another consideration in deciding which loan to pay off first is whether you are receiving a tax deduction for any of your loan interest. Student loan interest is tax deductible up to certain limits. For 2015, a deduction was allowed for those with modified adjusted income less than $80,000 for single people or $160,000 for those married filing a joint return and was limited to $2,500 in student loan interest. With regards to mortgage interest, it gets more complicated, but most people that itemize their deductions can generally deduct their mortgage interest. We will discuss more about these common tax deductions in the tax classes in the future, but the easiest way to see what benefit you are getting from being able to deduct your loan interest is to enter your tax information in a tax software such as TurboTax and look at the amount of tax owed with and then without each of these interest deductions.
To use the loan amortization table, you need to enter the original information from the initial date of taking out the loan and not the current date and current balance. If you absolutely cannot find this information, you can enter your current balance in the loan amount and the remaining loan period. Be sure to reconcile the balance of the loan on the loan amortization schedule for the current date with the amount that the bank says that you owe. If there are differences, you can look online for account activity and see all the payments that were posted to your loan account and where the lender applied the payments. You can also call the bank and request a loan amortization schedule from them. Be sure to enter any additional payments you’ve made in the past in the “Extra Payment” column.
After you’ve created loan amortization schedules for each of your non-revolving loans, you can go back to creating your plan to pay extra on your debt. If you go back to the spreadsheet you created in the previous debt class Debt Management 101 to pay off your credit card debt, you can actually add to it your remaining loans from this class using your current principle balance, remaining term, monthly payment and interest rate. See the Smith family example in the section below.
EXAMPLE: THE SMITH FAMILY
Here is an example of one of the Smith family’s loan amortization schedules (for their car loan). They purchased the car used from a dealership for $20,000 in May 2014, paid $1,500 down and financed the remaining $18,500. As you can see, as of January 1st, 2016 they owed $12,789 on the car.
The Smith family has already made a plan to pay off their credit card debt by the end of 2017 by paying $200 extra per month and $2,000 that they had planned to spend on their vacation in the summer. After that is paid off, they plan to keep making $200 extra payments plus use all the money they were using to pay off those debt minimum payments toward their other longer term debt.
They also can expect an increase in their income year by year and that extra money they will be putting toward their savings goals, such as an emergency fund and cash reserve, a new car and retirement, as well as family vacations and activities. In addition, they will most likely adjust this schedule to reduce the extra paid toward their mortgage and put it toward retirement starting in June 2018.
Your homework assignment is to create amortization schedules for each non-revolving loan that you currently have outstanding. Start with your original principal balance if you can and reconcile any additional payments made on your loan.
- IMPROVING– After paying off your credit card debt, determine how much you can afford to pay from your budget toward your long-term debt payments and automatically transfer that amount each month in addition to your monthly payment. Start by paying off auto loans, then student loans, then mortgage loans.
- INVESTED– Request amortization schedules for your long-term loans from your lenders. Enter the current balances of your loans, the monthly payments and interest rates in the payoff schedule from the previous class DM101 to calculate a payoff date. Include extra payments you can make toward your debt.
- UNSTOPPABLE– Create separate amortization schedules for each of your long-term debts. Reconcile current loan balances from the schedules to your monthly statements. Enter current loan balances, interest rates and monthly payments in your credit card payoff schedule from the previous class DM101 and set a goal for additional amounts you will pay each month and how long you will be before you pay off each debt.
File your amortization schedules in your Financial Plan binder under Tab 2-“Debt Management”.
HANDOUT: DEBT STATISTICS IN THE U.S.
Note: This class is not intended to cover everything about debt, but just a basic overview. If you have a large amount of debt or are unable to make your monthly debt payments, I highly recommend that you do a lot of research and consider meeting with a nonprofit credit organization to get help for your specific situation.