The other day I was looking at the amortization for the loan I took out to buy our 2007 Honda Civic. The balance on the loan is now below $10,000 and I immediately thought about paying more on the loan just to get it paid off earlier.
But then I noticed something that I never really noticed before (I noticed it before but never really thought about it): My extra payments wouldn’t save me that much in interest. Why? Well, it has to do with the way loans are structured. When you take out a loan, the payment is calculated based on the length of the loan, the interest rate on the loan, and the amount of the loan.
I’ll use our Honda loan as an example. Here’s the necessary information:
Interest Rate: 7.3645%
Period Rate: 0.6137%
Loan Term (Years): 3
Payments per Year: 12
Total Number of Payments: 36
Amount Financed: $15,019
Payment Amount: $466.26
Here’s what the amortization for this loan looks like (you can click on it to see a larger version):
Take a look at the first payment:
The beginning balance is $15,019. The interest portion of the $466.26 payment is $92.18 which is calculated by multiplying the beginning balance ($15,019) by the periodic rate (0.6137%). The remainder of the payment is applied to the principle, which becomes the beginning balance of the following month.
Each month the balance on the loan decreases, which makes the periodic interest payment smaller. This leads us to the point of this post:
In order get the most benefit from making extra payments on a loan, you need to make them at the beginning of the loan. How much difference does it make? Let’s see.
I ran two scenarios. The first one assumed an extra $50 each month for the final 18 payments and the second scenario the extra $50 was applied to the first 18 payments. Here’s what the two amortizations look like:
Under the normal amortization for this loan, the total interest charges for this loan would be $1,766. By making extra payments at the end of the loan, you would pay $1,720 in interest, giving you savings of about $46. By making extra payments at the beginning of the loan you save $155 in interest. No, it’s not a lot of money, but this is a short-term loan. Imagine how much the saving would be if this were applied to a mortgage.
Of course there are other things to consider when doing this math. For instance, you have to look at the opportunity cost of the $50 you are putting towards paying off the loan early. Could you put that money to better use elsewhere? That’s something you have to ask yourself.
Anyway, the next time you are tempted to accelerate the payments on a loan, ask yourself how much you are actually going to save by paying it off quickly. You might be surprised to find out it’s not as much as you thought.