NMHD Budget Clinic – Episode 3 – Loan Amortization Schedule (AKA Loan Prison Sentence)

In this episode, I show that Max can save a substantial amount of money by paying down his student loans early to avoid interest expenses. His $26k loan will ultimately cost him $35.9k if he makes the standard $300 monthly payments over the 10-year term of the loan because the interest at 6.8% comes to $9.9k.

My finance profs would kill me for saying this, but there’s really no need to understand the math behind this thanks to the internet. The interest component of each of Max’s monthly student loans can be determined by heading here to view his loan amortization schedule. A loan amortization schedule shows how much each of Max’s $300 monthly payment on his 10-year $26k @ 6.8% loan is comprised of interest versus principal.

I like to think of the loan amortization schedule as a sort of prison sentence. It explains exactly how much time Max is going to serve paying off the principal and interest components of his loan and how much extra he has to pay per month to get out of prison early for good behavior.

Principal is the amount Max borrowed when he went to school; it’s the $26k. This is the “meat” of his student loans. Paying down principal is good because it reduces his loan amount.

Interest is, simplistically, the profit the bank makes on Max’s loans. It’s the fat of the loan. Paying off interest occurs as a function of how long Max stretches out his loan payments. If he make the standard $3oo monthly payments versus making extra payments, he’s increasing the amount of interest he pays.

If Max makes the standard 12 monthly payments of $300 in Year 1, he’ll pay $3,600, but he’ll pay down only $1,880 of his $26k loan and he’ll pay a whopping $1,710 in interest. That’s a lot of fat! These figures are based based on the rate at which his loan amortizes, or is reduced. If, however, on Day 1 of Year 1 he pays $1,880, he will completely save the $1,710 interest expense. Because he attacked all of that meat on Day 1 instead of stretching it out over 365 days, he saves $1,710. So his $9.9k of interest due goes down by $1.7k to to ~$8.2k. In prison terms, he’s being rewarded and getting time off of his sentence for good behavior.

Some people are paying off their loans so slowly–even less than the standard payment rate, which in Max’s case is $300–that they’re paying only the interest portion of their loan or less. This is a bad situation because they’re not attacking their principal, the meat of their loan, which means they’ll never pay off their loan. They’ll continue to serve the prison sentence indefinitely because of “bad behavior.” The only way to pay off a loan is to pay off the principal.

When Max starts paying down his loans at the standard rate, almost half of his $300 monthly payment will go towards interest and the balance will go to principal. This explains why I still owed $91k of principal after I paid $20k of my $101k of student debt principal in two years at the standard repayment rate. It was only when I got serious about punching my debt in the face and made some extra payments that I paid it off early and saved $30k of interest.

At a standard payment rate, the bank is guaranteed to make all of their profit, via interest, before Max pays off the entire principal.

So, Max’s key to speeding up his debt pay-down timeline is to maximize principal payments and minimize interest payments. The only way to maximize principal payments is to make extra payments because extra payments go straight to principal. Tactically, this means Max would pay $300 when it’s due. Some will go to principal and some will go to interest. Anything else he pays along with the $300 will eliminate principal, thereby reducing the amount he’ll ultimately pay in interest.

There are lots of ways Max can make extra payments on his loans, and we’ll explore this in future episodes. In short, he can either cut back his spending in other areas of his life and put those savings towards the principal, or he can make more money and put that extra money towards his loans, or he can do what I did and do both for a combo knock-out move.

As we go through future episodes, we’ll keep tabs on Max’s prison sentence to understand how his extra payments are reducing his prison sentence.

If any of this is confusing to read, check out the vid–hopefully that helps. And if it doesn’t, feel free to ask questions in the comments section.

Reminder: For best results, view this clip in full screen and set the resolution to 1080p.

Episode 3 Materials

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6 Comments

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6 responses to “NMHD Budget Clinic – Episode 3 – Loan Amortization Schedule (AKA Loan Prison Sentence)

  1. Rebecca

    You discuss making the regular payment that goes toward interest and principle and then making another payment. (before the next payment is due.) If I read correctly, the additional “interim” payment all goes toward the principle. Is this correct, and is it the same for paying off credit card debt? I usually make one large payment for the month right after my credit card statement closes for the month. For example: The min payment is $100 and I make a $1000 payment right after the statement closes (so as not to accrue more interest) and that is it. Should I make the minimum payment when my statement closes and then pay the rest during the month – or does it matter? Love your posts! Thanks.

  2. Good question, Rebecca. Credit cards are actually a pretty strange beast. I did some research and come across a really good resource here: http://www.creditcards.com/credit-card-news/minimum-credit-card-payments-1267.php. It sounds like credit card companies have to make the minimum payment big enough that you’re at least paying down some of the principal so that you can eventually get out of debt via the minimum payment plan. If they made you pay interest only, you would end up never paying off the debt.Good for them, bad for you. But it’s not really clear how much of the interest you’re paying off with that minimum payment, and that amount can even vary from bank to bank as minimum payments are not an industry standard. From the article I mentioned: “For consumers, a credit card minimum-payment-due amount can be a mysteriously shifting figure that can make a significant impact on the monthly budget.”

    Credit cards are trickier than student loans because your principal is growing as you continue to make purchases with your card, whereas the principal of a student loan will never grow (unless you’re not paying down enough to keep up with the interest that’s accumulating each month.)

    This isn’t a situation where you can go to the amortization calculator site and plug in your principal and APR because the term of the loan isn’t defined. And your principal will grow as you continue to make purchases with the card.

    I think you should call your bank and have a talk with them. They should be able to offer you a lot of guidance on this one since it’s a pretty common thing.

    To prep for that call, Ready for Zero has a couple of great resources you should check out:
    How Does Credit Card Interest Work?
    http://blog.readyforzero.com/how-does-credit-card-interest-work/

    The Myth of Minimum Payments
    http://blog.readyforzero.com/the-myth-of-minimum-payments/

  3. It’s always a nice reminder to see how much one early payment can make. It definitely keeps me motivated to not only apply extra each month to my loans, but also to put any additional freelance income I make towards them as well — it can be so tempting to go into “i deserve to spend this on myself” mode. But really, extra payments towards a loan are a lot more meaningful to my overall happiness in the end: that much closer to financial freedom!

    • Absolutely. I think everybody should print out their prison sentence at with their monthly payment schedule and put it on their fridge or next to their computer or whatever so they can see how much interest they’re paying each month. That would motivate the hell out of me.

  4. Pingback: Student Loans and Picking Your Own Prison Sentence

  5. Tom

    As a side note on making extra payments to the principle of your debt, be sure to check with your lender first before making a payment. In talking to Wells Fargo (which owns my private portion of debt) I can only make extra payments to the principle on the day my regular payment is made. Otherwise, the extra payment will go toward principle and interest.

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