I've been taking a Bible study offered by Crown Financial Ministries. It's a well put-together study that involves scripture memorization, Bible verse study, group discussion, practical exercises, and more.
This past week's topic was debt, and not surprisingly, the Bible doesn't have too many good things to say about debt 🙂 and encourages people to avoid almost all kinds of debt, and to get out of debt as quickly as possible.
Part of the discussion within one of the workbooks revealed a nice illustration of how paying extra on debt saves interest expense over the life of the loan. All that's needed is an amortization schedule.
Let's take a 30-year fixed-rate mortgage with starting principal of $100,000 and a rate of 5%. The monthly payment is $536.82. Here are the first five payments, split up by principal and interest, and the balance after making the payment:
For the first $536.82 payment, $416.67 goes to interest, and $120.15 goes to reducing the loan principal to $99,879.85.
Now let's say that I wanted to retire the loan faster by paying extra toward principal reduction. This saves me interest in the long run, but how much?
Let's say that I make an extra principal payment with my regular first payment. Let's say also that the extra principal is $120.65, which is the principal part of the second payment (in bold below).
My balance then is then $99,759.20. So, I've arrived at the loan balance I should have after the second payment, without paying the interest part of the second payment. Therefore, I saved $416.17 in interest by making an extra $120.65 payment when I did.
That's one of the clearer explanations I've seen for how you save interest by paying down a loan faster.