amortization – >_bryanallott.net

It’s a popular way to sell vehicles these days; the balloon payment. The sales and marketing will tell you that it brings down your monthly installments and at the end of the finance term, the dealer will buy back your car to cover that balloon payment (guaranteed, terms and conditions apply) or you just refinance/settle that outstanding amount. Sound good?

This payment is also known as a bullet payment: because it’s like a bullet to the head. Sound harsh? Not when you know what’s really going on in the maths. And keep in mind, the residual offer is also made available to folk who are “high risk” or simply cannot afford the regular payment. In other words, people who are already financially marginalised. Let’s have a look see…

Note: numbers have been rounded to make the reading easier…

The list price on a vehicle is R330 000. Terms are over 60 months. Interest rate: 11.5%. On a regular loan, you can expect to pay back R7200/month. Once you’re done paying for the car, you’ve paid back R435 453.63 (or financed R105 500 in interest over the 5 years). Ha, you think that’s bad?

Let’s apply a 30% balloon payment to the same offer. Your balloon payment is R99 000. Your monthly payment is now down (the “good” news) to R6 000/month. Over the term, at that repayment, you’ve paid back R361 800 (or what might look like R31 800 in interest). Wow. Sounds great! BUT, you still owe R99 000. Now even if you paid off that R99 000 in one go, you would have paid R130 800 extra for the same car. So where does it all add up…?

That R99 000 payment at the end of the term is discounted back to today’s value (at the deal’s terms and interest rates) to a value of R55 860. The loan that you actually end up applying for is NOT R330 000 – R99 000. It is in fact R330 000 – R55 860, a value of R274 140. That’s why your repayment is lower- but not that low. That R99 000 represents a “discount” you get today but you still pay interest on it until you pay it off. Effectively, you’re financing 2 loans. You have actually financed R87 600 in interest (compare that to R105k on the traditional loan)

One for R274 140 at R6 000/month, another for R55 860, except that in case, the monthly payment is deferred in lieu of paying the whole loan off in one go at the end. Still sound good? Of course, if you have the extra R1200/month lying about, pay it in, but you might need to stipulate wether this is a payment towards interest, capital or the residual. Getting complicated?

Now, unless you have that amount lying around after 5 years of paying a premium, you’re probably going to need to refinance that R99 000. The terms and interest of that loan don’t exist today and still have to be negotiated. Let’s assume you manage to refinance that R99 000 on the same terms (unlikely), that’s another 5 years at R2 200/month for a grand total of R130 600.

In all, your R330 000 car, with a 30% residual refinanced, now costs you R361 800 + R130 600 = R492 400 over 10 years. The traditional loan is R435 500 over 5 years.

Now, just looking at the whole deal, you can decide for yourself wether that’s worth it or not. Depending on where you’re investing, spending, saving, it might actually be a worthwhile avenue. Or it might not.

Just keep in mind:
* you’re paying off two loans when you opt for a residual value
* the residual amount represents a discount you receive today that’s already been compounded with interest
* you’re effectively applying for finance at the list price less the discounted price
* the dynamics of the interest on the residual are hidden from view

Happy financing!

Morty is a pet project i been working on here and there which spills out an amortization schedule for you, based on your loan attributes. I’ve been incubating it at Heroku since it is quite a fascinating concept and tool. Their online console is pretty geeky but easy to use and deploying rails apps is straightforward really. Anyhow…. Morty.

Say you considering a loan for (in any currency) $150000 at an annual interest rate of 12%, compounded monthly over 5 years (or 60 compounding periods). Immediately you get an idea of how much your repayments are going to be.

In this case, 3336.67 per month. The schedule part is the interesting bit; if you are indeed interested. First, you can see, at a glance, how your equity in the loan grows and how quickly (slowly) the loan capital is repaid over time.

As you can see, it’s only just after halfway that you start to owe less than you’ve repaid. You will notice slight curves due to the nature of amortization. Experiment with bigger loans and interest rates to see just how the curve is affected.

You can also see how much total interest you end up paying, versus how much of the interest you’ve paid off so far.

Here, the curves are slightly more pronounced. Of the Â±50k interest you’re going to pay back in total, most of it is paid off quite early. Which makes sense. The more you owe in the beginning, the more interest you pay. So if you really want to make a difference on the interest on your loan, over time, make the biggest impact you can as early on as possible. You can see that towards the end of the loan, how flat the curve is. If you start making advanced payments at this stage, you’ll still save, but not nearly as much as you could have if you were even one or two months earlier with that payment…

The schedule…

Numbers number numbers. All it is is numbers. The numbers tell you that when you make your first payment of R3336.67, almost half of that payment is paying back the interest. R1500, in this case. So, in effect, you’ve only paid back R1836.67 of the capital (R150k) back after actually paying R3336.67. That starting to make sense now? Sucks, eh? So you make another payment, through enforced religiosity (ie. debit order). This time, you’re _only_ paying back R1481 interest. The balance pays off the capital. And so it goes until eventually you reach a stage where you’re paying off more capital than interest with each payment.

Now take a look at your home loan. An average value in current property markets might be something like R800k at 14% over 20 years (or 240 compounding periods). You’re paying back almost R10k every month but your first 42 payments don’t even dent the capital by more than R1000 at a time. Effectively, after 3.5 years, you’ve paid over R420k back, but still have R767k out of the original R800k owing.

Eish. That’s why credit is so expensive and not everybody can afford to jump into the property game.

Which also brings me to another point… a parting shot, if you like. Think _very_ carefully about the impact of renegotiating your outstanding debt. Imagine: 3.5 years later, and almost half a million out of pocket, you get ~~a generous offer~~ an opportunity to renegotiate your existing debt. In essence, you start all over again. Remember the curve! Another 3.5 years later, another R400k out of pocket, and you’ve only managed to claw back R35k, give or take. Sound like a smart move?

**NOTE: Different institutions structure fees into their loans, so the actual repayments may vary if you ask them for quotes and compare to this calculator. Query the fees. Always.