IN THE PREVIOUS section, we assumed you didn’t pay the interest on a loan or repay any of the sum originally borrowed. Instead, the amount owed was allowed to balloon in value. This is unrealistic. Most loans are amortizing, meaning that each month you pay not only the interest charged, but also repay part of the sum originally borrowed.
A classic example is a 30-year fixed-rate mortgage. The payment each month stays the same. That payment is set so that not only do you pay the interest incurred each month, but also you gradually reduce the loan’s principal balance, with the goal of repaying the entire sum borrowed after 30 years.
While the monthly payment stays the same over the 30 years, the amount that goes to interest and principal changes each month. In the initial years, most of the monthly payment goes toward interest. But as the loan balance shrinks, less interest is owed each month and more money gets directed toward paying down principal.
To see what this sort of amortization schedule looks like, try the mortgage calculator at Bankrate.com. Let’s say you take out a $200,000 30-year fixed-rate mortgage with a 6% annual interest rate, equal to 0.5% per month. The mortgage payment would be $1,199.10 per month.
In the first month of the loan, when the loan outstanding is $200,000, you would pay 0.5% of that sum in interest, or $1,000. That leaves $199.10 that can be put toward principal.
In the second month, the loan outstanding has shrunk to $199,800.90, thanks to the prior month’s principal payment. The 0.5% interest cost on that amount comes to $999. That means a slightly larger sum—$200.10—can be put toward principal. And so it goes for another 358 payments, or 29 years and 10 months.
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