All Forum Posts by: Eric Jones

@Chris May 

As Chris and I have mentioned, amortization has nothing to do with how interest is calculated, it has to do with how the payment is calcuted. Basically, in the above example, $632.41 is the monthly payment at which a 150K loan will get paid off in 360 months @ a 3% interest. This is the correct way to understand amortized loans - it's about the payment, not interest. Interest is purely a function of balance, rate, and compounding periods.

@David Dachtera - doing it the way you described. This is incorrect, because Column E ("pmt (p + i)") is not correctly calculated. 

So here's the results from YOUR 10-month table:

Since the 150K loan is amortized, the correct formula to calculate your monthly payment is:

A1 = "3%" interest rate per year

A2 = "360" compounding periods

A3 = "$150,000" beginning loan balance

A4 = enter the following payment function for an amortized loan "=pmt(A1/12, A2, A3, 0, 0)" = should give you a monthly payment of $632.41

The correct 10-month table looks like this: (note that you're making the same payment of $632.41. As I suspected, you're splitting up the payment, which you shouldn't be. It should be fixed every month.

Make sense now? 

@Account Closed - Brent, you should do the exercise too :)

@Joe Au - agreed, but only if your payment is a cash/non-debt payment. Making a debt payment using other debt (like a HELOC) perfectly offsets the gains, assuming the same interest rate. The reason for this is simple - you're just transferring debt. The interest rate determines how quickly interest accumulates on each dollar of debt, so it's proportional with size. It's a perfectly linear relationship. A 100K balance accrues interest 100X faster than a 1K balance. 

Hoping that David does the exercise I suggested. It will be very revealing...

@David Dachtera

David, like Chris I also work in finance - I'm a financial analyst and set rates for a utility company and do financial analysis for a private equity firm. I also have masters degrees in both engineering and finance. Chris is 100% right in what he's said. The confusion seems to be with your understanding of the payment on an amortized loan. You're thinking of the payment being divided into two pieces, but this is technically an incorrect way to think about it. The correct way to view your payment on an amortized loan is to first take your loan balance and then multiply it by the interest rate/number of compounding periods. This will give you the interest that accrues over the month. Then take the loan balance + the interest you just calculated - the entire payment. The result is your ending balance after accounting for interest and the payment. The problem, I believe, is you're not subtracting the entire payment. You're dividing the payment up, which you shouldn't be. 

Can you do an exercise for me?

Say you have three debts: a 150K amortized loan, a 147K amortized loan, and a 3K HELOC. Assume all are at a 3% interest rate. After the first month, how much interest did you accrue on each?

Also, if you want to take it a step further, what is the ending balance on each, assuming you make the minimum payment (and an interest only payment on the HELOC). Note: the monthly payment on the 150K loan and 147K loan should both be $632.41, since both originated as 150K loans - the difference is you paid down one with $3K from your HELOC...

Don't worry about future interest or payments on any of the debts - just focus on month 1. The net interest is the sum of the interest incurred in each individual month, so if we can demonstrate that you have no net savings in month 1, it follows that you'll never see a net savings in future months. 

@Chris May - 

"There's no functional difference in interest calculation between a revolving credit line and an amortizing loan. The only difference is in way you pay it off, but in the end that has no impact on the amount of interest paid."

Exactly. You hit the nail on the head. The interest paid is purely a function of the balance, interest rate, and compounding period. Amortization affects how the PAYMENT is calculated, not the interest. Like I've said, amortization isn't some magical phenomenon with a magical solution. The way to fight the high interest caused by an amortized loan is to prepay and get the best rate possible. This happens to be exactly the same way to avoid excessive interest on a HELOC.

Good discussion guys.

@David Dachtera -

Just did the amortization exercise you described. You're correct that applying 4 extra payments of $3000 with the HELOC will rapidly speed up the payoff. But that's assuming that you're making the payment with cash, not interest-bearing debt. When you pay down the loan $3,000 while increasing your HELOC balance $3,000, you're actually prepaying in a way. Think about it - you're still making the minimum payment on the loan for $632.41, but you're also paying $7.50 in interest on the HELOC ($3,000 balance * 3%/12). So what has happened is you're gaining $7.50 in equity for each $632.41 payment as a result of the HELOC payoff of $3k.

150K Loan  - for the first payment of 632.41, 375 goes to interest and 257.41 goes to principle.

147K Loan - for the first payment of 632.41, 367.50 goes to interest and 264.91 goes to principle. But then you also have a 3K HELOC balance which accrues monthly interest of 7.50. So your total interest paid on the first payment is 367.50 + 7.50 = 375.

So in the 147K scenario, youre saving 7.50 in interest on the loan, but paying 7.50 in interest on the HELOC. It's a wash, since they both have the same interest rate.

One last comment to serve as a sanity check: the claim being made is that you can pay down your 30 year mortgage in 8 to 10 years, simply by shuffling the debt around, with no net increase in your monthly payment. This is impossible for the following reason:

For a second, assume the 150K loan was at 0% interest, so everything you pay goes to principle. In that scenario, making your monthly payment of 632.41, you'd payoff the loan in (150,000 / 632.41 ) = 237 months. So... if a 0 APR loan would take 237 months to payoff, how could a 3% interest bearing loan take 96 - 120 months to payoff? That's impossible! I work as a financial analyst and it's good to do big picture sanity checks like this when analyzing different scenarios.

@David Dachtera,

The proof that I provided with the two scenarios really settles this whole debate. I suggest carefully reviewing that particular example and understand the math I did. 

If you claim that my math is wrong, go ahead and point out where. But I assure you it's correct. 

Lastly, I don't need to hear the explanation provided in the video by spending an hour and a half listening. Like I've said, I learned about this technique a while ago, after listening to similar videos, and I made up my mind to determine if it was legitimate. At one point, I too was convinced it was some magical payoff strategy that counteracted the amortization, but I wasn't accounting for the fact that I now have principal and interest on a HELOC to account for as well. You can't look at the mortgage in isolation, you have to analyze the starting and ending values of the mortgage, HELOC, as well as total interest and payments made on both. Only when you do this will it make sense. If someone told you to spend an hour and a half watching a video where they are trying to prove that 2 + 2 = 5, I doubt you'd waste your time with it. I provided a proof - please explain how the math in that proof is wrong.

Sorry, the formatting came out weird on that. The totals rows are the yearly totals for interest and payments. I can send the excel file if anyone wants it.

Okay, so I modeled the example that @David Dachtera used where you pay down $3k on a $150K mortgage using a HELOC and then just make minimum payments (interest only) on the HELOC. The results confirmed what I thought:

This proves that you can't just swap debt and expect to save money overall. The reason is simple - 3% interest on a dollar is the same whether it's a loan or HELOC. You can get some slight savings with a HELOC by knocking down the average daily balance over the course of a month, but that's about it.