This is part 1 of a 3 part series
Smart People Saying Dumb Things
We’ve currently experienced the longest run of low interest rates in history. It’s got many smart folks saying dumb things. A college-educated friend of mine says the current rates equate to “cheap money.”
While I agree that low interest rates are great for purchasing investment properties and spurring development, is it really “cheap money?”
Do you think banks would really loan “cheap money?” Before you answer, consider which entities usually have the largest buildings around: governments, casinos and banks.
What is that telling you?
What is Interest?
If you Google “interest,” you’ll reveal similar terms such as ‘charge’ and ‘fee.’ You’ll find them often put together in ways to say something like this, “a fee charged to borrow the money of another.” That doesn’t sound so bad, right? A ‘fee.’ It almost has a nice ring to it. Even ‘charge’ isn’t all that bad.
Words are important. In Rich Dad, Poor Dad, author Robert Kiyosaki suggested people stop looking at their homes as “assets” and start looking at them as “liabilities.” It changed the way I looked at my primary home.
I think we need to change the way we look at interest and I’ll explain it the same way I do to our nine year-old.
Interest is the PENALTY charged when you borrow money from the bank. – Colin @ Building-Income
Yipes. Penalty doesn’t sound good, does it? They put you in the penalty box in hockey when you do something bad.
We want to feel nice and snuggly about our money decisions. That’s why people get comfortable with words like ‘fee’ and ‘adjustable rate mortgage” and “refinance.” Those words should scare us. Instead, we get lulled to sleep by gentle sounding words.
If we look at interest as a penalty, we’ll keep it in the appropriate light as we move forward.
Why Do We Need Interest?
The simple and easy explanation is so the lender makes money.
I’m not faulting them for that. Everyone needs to make money. You need to make a dollar, I need to make one and the bank needs to make one. That’s reasonable. We shouldn’t be afraid of the banks for that.
Interest is also charged because of RISK. The higher the risk, the higher the interest rate. If you have sterling credit, you’ll often get the best rates quoted by banks. If your credit is less than stellar, you’re going to see that rate climb. If you have bad credit, you’re going to get screwed.
Here’s a reality you can never forget: Even with perfect credit, YOU are still a risk.
With your mortgage, you owe someone a large chunk of money. You could lose your job. Or worse you could wake up angry and decide today is the day that you will become a minimalist anarchist and throw everything away before burning down the system.
You are a person and people do wildly, irrational things. The bank is betting on you to be a decent person and pay your bill on time. Quit paying, though, and find out what happens.
Therefore, you are risky. It’s just a matter of degrees.
In any financial transaction, there are always two sides to consider. Their side and your side.
If the bank is looking at interest as an indicator of risk, why aren’t you?
What’s the Risk Your Taking?
The bank has calculated in to their risk the cost of default and how likely you will do something abnormal. The bank does its homework and they know who you are.
What they don’t know is your dreams. The don’t know my dreams. It’s obvious we’re not taking this into our consideration, either. We’re committing our future selves into paying back the bank the money it loaned us plus interest when we could have been doing something else with that money.
The extra money we pay to the bank will never be recovered. It’s gone. They created wealth through interest due to our inability to save first and spend second.
“Well,” you say, “I can get a mortgage today and still have money for other investments or to fund my dreams elsewhere.”
You’re essentially telling me, “It’s cheap money.”
You're forgetting something called Opportunity Cost which is a benefit you’ve given up in pursuit of another.
Thirty years of interest payments is costing you some opportunity. We don’t think about it because the money trickles out of our hands slowly. What’s the opportunity? Only you can answer that, but if you don’t look at it that way, you’ll walk around saying dumb things like “cheap money.”
The Amortization Schedule
When was the last time you looked at your amortization schedule? It’s okay, if you don’t remember. Most of us probably have never looked at it.
And that’s exactly why the mortgage industry thrives.
It wasn’t until recently that I started looking at my amortization schedule every month. Then I studied the schedules of my commercial properties. When I did, this, my eyes opened to a new reality of how things are working against us.
You don’t know what an amortization schedule is? If you don’t and you have a mortgage, you should be frightened. That’s like driving a car with a blindfold on. You have no idea what you’re doing or where you’re going. It’s time to take the blindfold off and see what’s ahead.
Do you receive offers from your bank to refinance? Do you really believe this is to help you? Do you think they are offering this money out of benevolence?
We’ll get to those answers.
Investopedia defines Amortization as the paying off of debt with a fixed repayment schedule in regular installments over a period of time, for example with a mortgage or a car loan.
Sounds simple, right? Kind of boring and definitely nothing to be worried about.
Amortization Schedule Defined
Another Investopedia definition:
An amortization schedule is a complete table of periodic loan payments, showing the amount of principal and the amount of interest that comprise each payment until the loan is paid off at the end of its term
Again, nothing to scary in that definition. What's all the fuss then?
Get it Scheduled
Now, let’s get to the nitty-gritty. There are plenty of tools out there for you to call up an amortization schedule. I’m running the latest version of Microsoft Excel. If you go to File – New – then search in the Online Templates, you will find an amortization schedule template.
For this example, I used the following terms:
$200,000 initial loan
30 year amortization schedule
This results in a monthly loan payment of $1,013.37
If you pay to term, you’ll pay a total of $164,813.42 in interest.
You can download a pdf of the Amortization Schedule here.
Let’s take a look at how the relationship of principal and interest works.
Interest is weighted heavily towards the front of the amortization schedule.
This is an important, yet basic principal, but it’s the basic concepts that we often forget first.
The very first payment in my example has $263.37 towards principal and $750.00 towards interest.
One month later, that payment improves only slightly - $264.36 to principal and $749.01 towards interest. Geez, 99 cents worth of improvement towards principal. Impressive, huh?
At which point in the amortization schedule is the principal and interest payment in equilibrium? In other words, where they are essentially equal?
Month 176. 14.67 years! At this point, you will have paid $112,868.37 in interest and only $65,484.86 towards principal. The bank has front loaded 68% of its interest in the first 49% of this amortization schedule. And this is with 4.5% interest. That's a little higher than where we are today, but it's a hell of a lot lower than historical rates. This paragraph should shock you since we know inflation is coming.
Look at the graph above. You're really not making any head way until almost the halfway point of the amortization schedule.
Want to be freaked out?
The bank front loaded 50% of its interest in the first ten years (1/3) of this loan.
In the first five years (17% of the term) of the loan expect to pay 26% of the interest on this loan.
Remember, this is what my friend calls “cheap money.”
Here’s some interesting things for you to do with your amortization schedule:
Using the scenario above,
1. Change the interest rate to 4%. What happens to the total interest paid?
2. Change the interest rate to 5%. What happens to the total interest paid?
It’s amazing what just a 0.5% change does over 30 years, isn’t it?
3. Now, change the interest rate back to 4.5%, but lessen the term to 15 years.
If so much less interest is paid on a 15-year term versus a 30-year, why would the banks ever encourage you to take out that loan?
We’ll get to that answer (and more) in the next article, Your Friendly Neighborhood Bank Isn't So Friendly ...
When's the last time you looked
at your amortization schedule?
I'd love to hear from you.