10 July 2012

Front Loading Interest...Really?

Much like low interest rates, these small skid
loaders can still load quite a lot over time.
What is Front Loaded Interest?
One topic that comes up a lot with loans is the interest rate being charged and how the charge is levied. A common myth that is often perpetuated is that the interest is "front loaded" on loans. What they mean is that for a certain period of time, the major portion of the money being sent in covers the interest, with hardly  anything going to pay down the principal itself. This can be seen if you run the numbers in a mortgage calculator. Naturally, people view it as a predatory practice of the banks to rip people off, but is this really what is going on?

While based on the example I posted above, it definitely looks like the banks are indeed throwing all the interest on the beginning of the loan, a more logical explanation is in order. Keep in mind that the loan is structured to have a 30 year payoff schedule. In the interim, the loan still is subject to interest. The thing is, the interest is not a single charge over the life of the loan. It's called an annual percentage rate for a reason: it gets charged each and every year (simplified version--in real life, it usually is computed more like monthly or daily) on the remaining balance. Therefore, as long as the loan is open, they'll charge that rate to the entire remaining balance.

With that in mind, you can see why interest payments take ~15 years to fall below principal payments as a portion of total payment sent in. Using a hypothetical loan of $200k and 4% APR (like in the link above), you can see without too much effort that the interest alone on the initial balance is ~$8000 for the year. So when the total loan payments for the year are less than $12k, then less than $4000 is actually going for the principal. Second year runs similar, with interest payments still totally nearly $7800 of the $12k being sent in. The third through sixth years all also show small drops in interest, but are still quite substantial as portions of total payments. In fact, not until year 16 do interest payments fall to less than 50% of money being sent in. It takes so long for money to finally go to principal vs. interest because in the early years, hardly any money is going toward principal.

While the example certainly seems to lend credence to the accusation of being front loaded, you can see the real reason: high balance means high interest charge. So it stands to reason that if the balance could somehow be reduced faster, then interest will go down fast as well. The banking industry has realized some people might not like sending most of their money as interest and so 15-year mortgages also exist. As a bonus, they also usually have lower interest rates. On the other hand, they also usually have much higher monthly payments. But in exchange for that higher monthly payment, you can get better bang for your buck immediately and over the life of the loan. From the very beginning, about 60% of the monthly payment goes towards the principal, and that percentage climbs as the loan is paid down and less interest is charged.

Now you can be in a much better position to make decisions regarding financing, whether it be a mortgage or not. As I mentioned in my previous post about interest, financing costs can end up costing a fortune over a time period. Although I've used a mortgage here for an example, this discussion applies to virtually all loans. Mortgage just works well here because the length of time involved and because it's also where the charge of "front loaded" interest is often placed. But now you can see that the real story is that the loan balance is high, therefore the interest is greater. What is also means is that if you send extra money, the interest charges will be diminish quicker and therefore paying off the loan earlier (and cheaper). Of course, the early payoff debate is quite a heated one, with no set answer. I'll leave that decision to you to make in conjunction with someone more knowledgeable about your specific situation.

Other Reading:
The 15 vs. 30 Year Mortgage Debate - LenPenzo
Pay Down the Mortgage or Invest More? - MMM

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