PRINCIPLE ON LOAN
Keep an eye on where your payments go.
Any time you borrow money, there are two components to the transaction. There’s principal, and there’s interest. In previous posts, we’ve talked about different ways of charging interest — fixed rates, variable rates and blended rates — but today we’re going to talk about principal.
If you borrow twenty dollars from a friend (let’s call her Michelle), chances are you won’t pay interest. Come payday, you’ll meet Michelle, give her a twenty-dollar bill, and call it even.
As a friend, Michelle is most likely happy with that. She probably won’t stop short and say, “Excuse me, but you owe me another dollar. ” That’s because Michelle isn’t charging interest. She’s only concerned with the twenty bucks she lent you in the first place. She’s concerned with the principal, which is the outstanding amount of the loan.
If a bank or other lender gives you that twenty dollars, they’ll charge you a fee for borrowing the money — interest — and you have to pay that part first. Imagine that you present Michelle with a twenty-dollar bill, and she says, “Okay, first buy me a chocolate bar.” You come back with $19 and a chewy treat. She grabs the candy, counts the money and says, “You owe me another dollar.” In this case, you’ve paid down $19 of the principal, and a candy bar’s worth of interest. There’s still one dollar left on the principal, so you still owe Michelle that loonie. (Whether she calls you a deadbeat depends upon just how close a friend she is…)
As we’ve discussed before, mortgages involve numbers much, much larger than $20. In the first year of a $300,000 mortgage*, a $672.67 biweekly payment would pay down the principal by $300.45, but include $372.22 of interest! The good news is, any additional payments you’re able to make are applied directly to the principal.
We’ll discuss compound interest in a later blog post, but for now, think about this: even a small amount, like an extra $20 a month, will add up to significant savings over the course of a 25-year mortgage. In fact, you’ll end up paying off that house sooner, perhaps even knocking years off the amortization!
Given that kind of incentive (and a candy bar or two), I’m sure Michelle will be happy to help out.
* $300,000.000 mortgage with a 5 year term and interest rate of 3.25%