How the Bank Applies Your Loan Payments
Is the bank applying your loan payments correctly? You can only be sure of this if you calculate and monitor how much has been applied as payments on your mortgage loans. That way, you can reconcile your loan balance against the bank's records, especially if you've been diligently paying your monthly obligations.
Perhaps you may have overlooked the fact that borrowing money from a bank is a lot different from borrowing from a family member or a friend. A bank imposes interests on every loan since borrowers are using funds entrusted by depositors. Banks as financial institutions are mandated by banking laws to loan out said funds to the most credit worthy borrowers. Doing so enables them to generate funds to pay for the interests on bank deposits. The service fees on the other hand, are the means by which banks can earn their upkeep.
Knowing how to figure out loan payment applications will give you a better understanding of how your monthly remittances reduce the principal mortgage loan. Keep in mind, that there's a standard procedure being observed by banks and financing institutions.
Understanding the Distribution Protocols of Loan Amortizations
Basically, your monthly statement carries the amount due on the principal and the amount due as interest. They will be applied as such except in cases when there are payment defaults. Those are the instances that deviations in loan payment applications will arise. Paying an amount that is less than the amount due does not change the distribution protocol; hence, any deficit will likely create more deviations that can adversely impact your loan balance. Here's how:
1. If you incurred any delay in remitting your monthly amortization, the late payment fees for defaulted payments will have first priority on the subsequent mortgage loan payment you made after the defaulted payment.
2. After satisfying the late payment fees, the remainder of your payment remittance will be applied as payment for the regular interest of the mortgage loan.
3. After satisfying the late fees and regular interests, the remainder if any, will be applied to reduce the balance of your principal mortgage loan.
For a more comprehensive illustration of these standard procedures, the succeeding sections will give you a guide:
To illustrate the standard procedures observed by the bank, the following information will be used. Generally, this is the same protocol by which all other types of loan payments are applied.
The first step is to compute the basic principal amount and the basic monthly interests due on your loans; this is with the assumption that all interest computations are based on outstanding balances.
Supposing the bank granted you a mortgage loan of $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 this is the number of months per year.
To Compute for Basic Monthly Amortization of Principal = Principal ⁄ 360 months
Monthly Amortization on Principal = $200,000 / 360 months = $ 555.55
Amount due as monthly payment for mortgage loan principal = $ 555.55 per month
Computation of Interest per Month
Principal x Interest Rate / 12 months= Monthly Interest
= ($200,000 x 7%) / 12 months
= $14,000 / 12mos = $ 1,166.67
Amount due as monthly interest payment = $ 1,166.67 interest per month.
However, interests on long term loans are generally computed based on the outstanding balance. This means that after making your payment on the first month, your principal balance on the second month will be $199,444.45 ($200,000 – $555.55). The latter amount will be the base value for computing the interest due for the second month and the same principle is observed throughout the maturity of the loan. For a more comprehensive illustration on how interest payments for long-term loans are calculated, a related article entitled Creating a Loan Amortization Table Using Excel" features a more vivid depiction. .
To Compute for Basic Monthly Amortization
Amount due as monthly payment for mortgage loan principal + Amount due as monthly interest payment = Monthly Amortization Due
= $ 555.55 + $ 1,166.67
= $1,722.22 Monthly Mortgage Loan Amortization
If you have been paying the amortization amount stated on the billing statement, 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, hence the minimal effects of the monthly amortization on your principal loan. This is assuming that you have not defaulted on your payments on any occasion during the past ten years.
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.
Based on this rough and simple computation, you will perceive that the bulk of your monthly loan payments were applied as interest.
What Happens if You Did Not Pay the Required Amortization?
There may have been times in the past that you could not afford to pay the stipulated monthly loan amortization.
For this purpose, let us suppose you were able to pay only $1,000 instead of the regular amortization of $1,722.22. The following example shows how the bank applied your loan payment:
Interest $1,166.67 – $1,000= $166.67 representing unpaid amount of interest for the month.
The $1,000 you paid was used to pay-off interest for the month and in this case, it resulted to a default of $166.67 in interest for that month.
Your principal mortgage loan balance remained unchanged and was also considered in default.
Bank records showed that the amortization for the month was in default and therefore subject to late payment fees.
Past Due Principal $ 555.55 + Past Due Interest $166.67
Total Amount in Default or Past Due $ 722.22
Computation of late payment fees and total past due amount:
As a result, your next mortgage loan statement will carry the amortization due for the month plus the amount past due.
Suppose the bank’s past due rate is 1% for every month in default, then your statement will carry past due penalty interests.
Past Due $ 722.22
Penalty $ 7.22 ($722.22 x 1%)
Past Due $ 729.44
Computation of the following month's billing statement:
We will presume that the loan is only a short term borrowing; hence the interest rate is calculated on a straight-line basis.
Mortgage Loan Amortization Due for the Current Month + Past Due Amount Defaulted from Previous Month
= $1,722.22 + $ 729.44
= $ 2,451.66
Total Amount Due for the Current Month = $ 2,451.66
Understanding the Effects of Defaulting on a Monthly Amortization
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 the past due amount of $ 729.44 and the remainder will be a reduction of the interest due for the month. In our example, only $ 992.78 was left to pay-off the $1,166.67 interest due for the month, leaving $173.87 unpaid.
This will again result to another round of past due penalty based on the same manner of computation we illustrated above.
Unless you pay-off the total amount stated on the current billing statement, which includes defaulted amortization, the amount of unpaid interest increases. Corollary to this, the next round of penalty charges on the principal and on the interest will also increase.
It will reach a point where the regular amortization payments you make are being applied only as settlements of the past due interests and late payment charges. This is why no matter how diligently you pay for your monthly mortgage loan amortizations, the payments you made had very minimal or did not have any reducing effect on your principal balance.
By guided by these methods and learn how to calculate your loan payments for mortgage loans so you can discern your monthly billing statements. Be aware of the harsh reality of how the bank applies your loan payment, especially if there were payment defaults in between. Basically, this same principle takes effect on your credit card obligations, if you pay only the minimum amount instead of the amount due.
Reference Materials and Image Credit Section:
- Explanations and sample calculations were all based on the author's experience as a former Branch Accountant of a universal bank.