I’ve a lot of hits on my piece Any Magic Trick is Easy Once You Know the Secret. I want to take a second and thank everyone who read it and especially those who clicked like! In about the middle of it, I challenged the readers with this indented paragraph…
Here’s something you should try. Look up the “Rule of 78” it’s an accounting tool that they use to calculate amortized loan payments (Yes, that’s your home mortgage and car loans). Then walk into your local banks and mortgage lenders and ask the person who handles these types of loans what it is… I’ll tell you right now, about 95% of them won’t have a clue what you’re talking about, 4% of the remaining will heard of it but have no idea what it is, though they’ll think it’s used in loans. The remaining 1% will actually know.
Because of the importance that the Rule of 78 plays in mortgage and car loans I want to go ahead and explain what is and how it works. Originally it was “created” before there were computers as way to easily calculate a loan by providing a formula that allows the borrower to make consistent payments throughout the duration of the loan. At the time it made life easier both for the borrower and the lender who didn’t have as much work to do recalculating the payments every year to adjust the payment amount factoring in the reduction of principal and new interest amount owed. Which is what they’d have to do if they used simple interest on loans that have a long duration of repayment.
The Rule of 78 is also the reason why though you pay 28% or more on your credit cards and yet can qualify for a mortgage rate of around 6%…. Did you ever wonder about that?
I’ve included the Wikipedia link that explains the actual calculation process. Here I’m just going to give a brief example of how it works against you. I’m going keep this on the super simple explanation because I don’t want this post to be longer than the post I mention it in. So without further ado….
In basic terms this is how it works. Lets say your mortgage payment is $1000.00 a month for 30 years. Your payment book shows your 1st payment is $1000.00 dollars and so is your last payment. Where 78’s (I’m using cool slang here ;)) come in play on this, the actual amount you borrowed and interest rate are not important since we know that your total payment due each and every month is $1000.00 (if this hasn’t raised a red flag yet, it should have generated a serious HUH!?!?!?!!!!).
78’s effect how the payment is disbursed between what is paid towards the principal and what is paid towards the interest. So, once again keeping it simple this is what they do…
$1000.00= Interest paid $780.00 + principal paid $220.00
Last payment after 30 years.
$1000.00= Interest paid $220.00 + Principal paid $780.00
During the duration of the loan the interest is paid off first and the principal second with the percentages gradually changing over the years so you pay off most of the principal at the end of the loan. Why should this be a reason for concern? For several very important reasons.
- You pay significantly more interest, especially when the loan duration goes longer e.i. 15 year loan not a lot of interest paid relative to the amount paid on a 30 year loan.
- On a 30 year loan you pay the bank the amount it risked giving you the mortgage in 10 years. For example you borrow $100,000.00 you will pay about that much in 10 years and the remaining 20 years of the loan is paid towards the interest. So if you default on your last payment of the loan the bank can still and mostly likely will foreclose on you. Even though their risk (i.e. the $100,000.00) was paid back to them 239 payments ago and their only really out the interest.
- $100,000.00 loan for 30 years turns into $600,000.00 paid to the bank and your home has to exceed a value of $600,000.00 for you to be able to have any return on your investment in the property. Would you buy stocks on margin that had little or no ability to grow in value exceeding what you paid for them over thirty years? Honestly?
If you have kids and are paying a mortgage, they hit college about the time your 20 years into your mortgage (for some less, others more) with another 10 years to go. Think about that while your planning on ways to pay for their college education. At the 20 year mark the bank is 10 years into the gravy with 10 more to go. The modern computer age calculating loan interest is as easy as pushing a button so having a mortgage that slowly drops in monthly payments as the loan matures is easy, very easy. Honestly, who wouldn’t be happy to enter their kids college years with a mortgage payment lower than it was when they 1st took the loan, without having to move to a smaller house or pay more money so the bank will lower the monthly payment on the interest of the money borrowed and already repaid.
If I loan you $100.00 and make you pay me $600.00 to repay the loan they call it Usury
If a bank loans you $100,000.00 and makes you pay them $600,000.00 to repay the loan they call it Mortgage.
Sadly only one of these transactions is illegal…
Oh, with car loans the interest paid using 78’s (my last chance for cool slang! ;)) the short terms of the loan duration brings the amount of interest more in-line with simple interest loans. This is because the loans of 20+ years were rare when the banks started using 78’s.