Do you remember the time when you first borrowed money from a bank to buy a new home? You were so elated because finally you would be able to have the dream house you’ve always longed for. Everything seemed so perfect until you got a little tired of paying the monthly amortization and started wondering why, in spite of paying for quite a number of years in terms of amortization the principal amount you owe the bank is still substantial. Was the bank applying your loan payments correctly?
Borrowing money from a bank is a lot different from borrowing from a sibling or a friend. You are probably aware that a bank imposes interests on every loan. This is how they earn their upkeep, unlike if you borrowed from somebody close to you, simply returning the money and saying thank you will do.
To have a better understanding on how these lenders apportion your amortization payment, here is the order by which your loan is applied:
1. Interest on late or defaulted payments.
2. The regular interest of the loan.
3. The balance of the principal.
For purposes of illustration, we will use the following information.
The bank granted you a loan $200,000, payable in 30 years at 7% p.a. The simplest way to compute your monthly amortization is to divide the principal by 360 months, which was computed by multiplying 30 years by 12 months since that is the number of months per year.
30 years x 12 mos. = 360 months for the whole duration of the loan.
$200,000 / 360 months = $ 555.55 principal amortization per month + $1,166.67 interest per month (see computation below) will equal the amount of $1,722.22 as your monthly amortization.
Computation of interest per month:
$200,000 x 7% = $14,000; this is the interest per annum or per year
$14,000/12mos=$ 1,166.67 interest per month
Hence, if you were paying the amount of $1,722.22 every month let’s say for the past ten years, only $66,667 ($ 555.55 x 12 months x 10 years) has been deducted from your principal. The rest was applied as interest payment and does not have any effect in reducing your loan.
To countercheck, there is a remaining balance of $133,333 ($ 555.55 x 12 months x 20 years) add to it the paid-up amount of $ 66,667 and you have a loan amount of $200,000.
Hence, from this rough and simple computation, you will note that the bulk of your monthly amortization is applied as interest, which in no way reduces your loan.
II.
Suppose you are able to pay only $1,000, on the succeeding due date instead of the regular amortization of $1,722.22. This is how the bank will apply your payment:
Principal $ 555.55 will not be affected since the $1,000 you paid will be used to pay-off interest for the month.
Interest $1,166.67 will be reduced by $1,000 payment you made, hence the interest has an unpaid amount of $166.67
Past Due Principal $ 555.55
Past Due Interest $166.67
Total Amount Past Due $ 722.22
As of this date, your account already carries a past due amount which will be subject to penalty charges. Your next loan statement will now carry the amortization due for the month plus the amount past due.
Suppose the bank’s past due rate is 1% for every month of default, then your statement will now carry past due penalty interests.
Past Due $ 722.22
Penalty $ 7.22 ($722.22 x 1% )
Past Due $ 729.44
III.
Now, if you will disregard your bank’s current statement of account and continue to pay only the regular amortization of $1,722.22, all these will be applied to pay off only the past due amount of $ 729.44 and the remainder will only be a reduction of the interest due for the month, which will be $ 992.78.
This will again result to another round of past due penalty on the unpaid principal due for the month and the unpaid portion of the interest which is $ 173.89 ($1,166.67 - $992.78).
Naturally, since the unpaid interest increased, the next round of penalty charges on the principal and the interest will also increase. Unless, you pay-off the defaulted amortization, it will come to a point that the regular amortization of $1,722.22 will only be applied to satisfy the past due amounts.
This is now the harsh reality of how the bank applies your loan payment, especially if there were default payments in between. Now, you know why some people could no longer cope with their loan payments when defaults kept piling up.
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