Understanding Business Accounting For Dummies, 2nd Edition (28 page)

A good example to illustrate several of these points is a typical home mortgage loan.

Home mortgage example

The biggest loan in most individuals' financial lives is a home mortgage. Compared with a short-term car loan, a home mortgage loan can run up to 30 years, and the amount borrowed is usually much larger than for a car (unless you buy a Ferrari).

Suppose that you buy a second home and secure a £180,000 mortgage loan for 30 years at a 9 per cent annual interest rate. The loan requires equal monthly payments, so you divide the annual interest rate by 12 to determine the monthly rate, which is 0.75 per cent (or 3⁄4 of 1 per cent) per month. How much will each of your 360 loan payments be? How do you determine this amount? You probably assume that the lender's quoted amount is correct - and you'd be pretty safe in this assumption. But how can you be sure?

Relatively inexpensive hand-held business/financial calculators are available to quickly determine monthly loan payments. These handy tools have special keys for entering each of the variables of a loan. To determine the monthly payment in this example, we pulled out a calculator and punched in the following numbers for each variable:

N
= number of periods - 360 months in this example.

INT
= interest rate per period - 0.75 per cent per month in this example (these calculators expect that the interest is given in a percentage, so we typed 0.75, not 0.0075).

PV
= present value, or amount borrowed today (the present time) - £180,000 in this example.

FV
= future value, or capital amount owed after the final monthly loan payment is made - £0 in this example (which means that the loan is fully amortised and paid off after the last monthly loan payment; otherwise, there would be a
balloon
payment due at the end of the loan).

PMT
= payment per period based on the four numbers just entered - £1,448.32 in this example (which appears as a negative number, meaning that you have to pay this amount per month).

The big advantage of a business/financial hand-held calculator is that you can enter the known numbers (the first four) and then simply hit the button for the unknown number, which appears instantly. Another big advantage is that you can keep all these numbers in the calculator and make ‘what if' changes very, very quickly. For example, what if the annual interest rate was 8.4 per cent? Just re-enter the new interest rate (0.7 per cent per month) and then call up the new monthly payment amount, which is £1,371.31. The monthly payment difference multiplied by 360 payments is £27,725 less interest over the life of the loan. So you might decide to shop around for a lower rate.

The Financial Times Mortgage Affordability Calculator (go to
www.ft.com
and click on ‘Your money' and ‘Tools') works out your mortgage repayments at any rate of interest, over any time period, and with variable amounts of deposit.

Now, here's a short test to see if you've been paying attention. Suppose the lender did not charge interest - in other words, the interest rate was zero. What would your monthly payments be in the example we just used? The monthly payments would be simply £180,000 divided by 360 months, or only £500 per month. At a 9 per cent annual interest rate, you have to pay £1,448.32 per month. This does not mean that the extra £948.32 more per month, or £11,379.85 per year, is for interest. Interest is accounted for differently, and just how interest is accounted for makes a big difference to you.

Each mortgage payment is divided between interest and capital amortisation (capital repayment). For the first month, the interest amount is £1,350 (£180,000 loan balance × 0.75 per cent monthly interest rate = £1,350). Therefore, the first month's repayment of the capital is only £98.32. Right off, you can see that the loan's capital balance will go down very slowly - and that a 30-year mortgage loan involves a lot of interest. Lenders provide you with a loan repayment (amortisation) schedule. We encourage you to take a look - although trying to follow down a table of 360 rows of monthly payments is tough going.

Figure 4-1 presents the annual amounts of interest cost and capital reduction for this mortgage loan example. (We generated this data from a Microsoft Excel spreadsheet repayment schedule for the loan.) Note that the annual capital amortisation doesn't overcome annual interest cost until the
23rd year.
In other words, you pay mostly interest during the first 22 years! The right column in the figure shows how slowly the loan balance goes down.

One alternative that you should definitely consider when taking out a home mortgage is a 15-year loan instead of a 30-year loan. For this home mortgage example, the monthly payment on a 15-year loan is £1,825.68, which is an additional £377.36 per month. The total interest over the life of the 15-year loan is about £149,000, compared with £341,000 on the 30-year loan. The 15-year loan saves you about £192,000 in total interest over the life of the mortgage, and you own your home free and clear 15 years sooner. Of course, you have to come up with £377.36 more per month, which may not be possible in the short run. But after a few years of paying the 30-year amount, you can step up the amount you pay each month and pay off your mortgage sooner. Figure 4-1A (A is for
alternative
) shows the annual interest and capital payments for the 15-year mortgage.