My husband had to explain installment loans to me.

Yes, folks, while I humbly submit to you that I am brilliant, I am not infallible. I understand a lot of the standard financial wisdom, a good bit of the less-common but still useful wisdom, and even some of the more abstract concepts. However, there is one thing I simply cannot wrap my mind around, and it is how installment payments work. So, when you take out a mortgage or a student loan or a car loan, provided it is on a fixed interest rate, you have a set repayment schedule where you make a certain payment every month which pays off all the accrued interest and part of the remaining principal. As the loan runs its course, the interest and principal both gradually decrease. The rate at which they do this is called an amortization schedule. A really helpful amortization calculator can be found here. The concepts behind this are baffling to me, though my husband can write out the mathematical formulas for periodic payments without breaking a sweat (he's awesome, did I tell you that?).

Anyway, what keeps tripping me up is that I forget that the advertised interest rate for loans is an ANNUAL rate, not a monthly rate. So, for example, with a 6% annual loan, the monthly interest rate is really .5% of the principal balance. Usually your interest rate doesn't neatly divide into 12, which makes it harder to figure out in your head. So I was wondering if the interest must be paid in full every month or if you can pay the principal instead. He said that the payments are usually applied to the interest first and then the remainder goes to the principal, which makes sense. It also makes sense that you must pay some portion of the principal every month otherwise you will be in a negative amortization situation, where the total balance of the loan is increasing on a monthly basis. This is what a lot of creative home buyers are currently facing.

So this raises the question of a financial tidbit you hear so often: Make an extra payment to your mortgage broker every year, and label it as saying "apply this to the principal balance only." Doing this in the early years of your mortgage can take years off of the life of the loan, since early on most of your payments go towards paying the interest. For example, with a $200K loan at 6% for 30 years, it takes almost four full years of $1200 monthly payments before more than $250 is going towards the principal on the loan. It sounds like a good idea, but will it ultimately make a difference in the amount you pay altogether as opposed to just a straight-up extra payment? The answer depends on how frequently your mortgage interest is compounded. If the mortgage is compounded monthly, it won't make a difference provided you make the two payments within the same month (which would happen in some fashion or other, right?). If the mortgage is compounded daily, it will make a difference, but depending on how close together the payments are received, it may not be as dramatic as you think. My advice in this situation would be to make a timely payment for double the normal amount (say $2400 instead of $1200), allowing for the entire balance of the second payment to go towards the principal. This is the approach I have taken with my student loans and it has worked well. By paying them down aggressively when the rates on savings accounts were lower than the loan's rate, I have managed to knock seven years off the life of the 20-year loan. If rates fall farther, we might consider adopting this approach again, but it won't save us as much in interest as it has in the past, even though it will retire the loan sooner. This study does go to show that making extra payments early on in a loan (most likely when you can least afford to do so) will potentially save you a great deal of money in the long run.

Also, if you're capable of more abstract thought, you can see that it's a better deal to borrow as little money as possible. Here's one last example to illustrate that point, figures derived using this tool. Suppose you are purchasing a $200K house with a 30 year mortgage at 7%. If you have saved a 20% down payment, you'll only need to borrow $160K, which you will ultimately repay in full along with $223,214,24 in interest. In borrowing the full $200K, you will ultimately pay back the full principal along with $279,017.80 in interest. Providing your $40K down payment saves you $55803.56 in interest, not to mention PMI or potentially higher rates because of a greater likelihood for default, etc. This is too significant to ignore.